By Michelle E. Botwinick, C.P.A.
Don’t we all dream about winning the lottery? Hitting the jackpot? Scratching off the instant winner? There are several tax considerations, as well as important nontax considerations, that you should take into account if your lucky numbers are drawn.
First, you should be aware that your gambling winnings are taxable. This is the case for cash winnings and for the fair market value of any noncash prizes you may win, such as a car or vacation. Depending on your other income and the amount of your winnings, your federal tax rate may be as high as 35%. Your winnings may also be subject to state income tax at rates up to 6%. You don’t get any capital gains rate breaks for gambling winnings. There is not any income averaging to help lower your tax bill either.
On the other hand, you are entitled to a tax deduction for any gambling “losses” you had. These are taken as an itemized deduction but cannot exceed your winnings. If your lottery winnings are payable in annual installments, the installments you receive in future years are still gambling winnings, making losses in those future years deductible to the extent of the installments, even if you have no other gambling winnings in those years. Gambling losses aren’t subject to the 2%-of-adjusted-gross-income floor on miscellaneous itemized deductions.
To establish your entitlement to a deduction for gambling losses, you should keep evidence of the costs of your bets—including both the cost of your lottery tickets and of any other wagering you do, such as betting on races, casino games, etc. The evidence should consist of receipts for tickets, wagers, cancelled checks, credit card charges, losing tickets, etc. Make sure you do this for all the years in which you’re receiving installment payments of your lottery winnings. In some cases, taxpayer estimates have been allowed, but you shouldn’t rely on this. Documentary evidence is preferable by far.
You report your lottery winnings as income in the year, or years, you actually or “constructively” receive those winnings. In the case of noncash prizes, this would be the year the prize is received. In the case of cash winnings, if you’re required to take the winnings in annual installments, you only report each year’s installment as income for that year.
When your winnings are taxable on when you selected between a lump-sum payment and a series of installment payments. If—as is the case with most state lotteries—you had to make the choice when you bought the ticket, you include your winnings in income only when you actually receive them. In that case, if you chose the lump-sum arrangement, you must include the entire lump sum in income in the year received. If you chose the installment arrangement, you must include the annual payments and any amount designated as interest on the unpaid installments in income as received.
A common arrangement is for family members or officemates to share the cost of a lottery ticket. However, depending on the arrangement, you may still wind up paying tax on the entire amount. The key is to establish that the ticket was owned by multiple persons—you and the persons with whom you are sharing the prize— before the ticket was declared to be a winner. If you can do this, then you and the other co-owners of the ticket each report only your individual shares as income.
But if you can’t prove co-ownership—or if you in fact simply win and then give away part of your winnings—you will be subject to income tax on the full amount of the prize. In addition, you will be treated as having made a gift of the part of the prize that you give away, and you may be subject to a separate gift tax as high as 35%. Be aware that IRS is likely to question the validity of a claimed co-ownership arrangement if the co-owners are all members of the same family. In that case, it is especially important to be able to establish by documentary evidence that the co-ownership arrangement was properly set up before the lottery ticket was found to be a winner.
Professional advice should be sought in the case of divorce or death. If you’ve won a lottery while married, and later divorce or separate from your spouse, you must exercise great care in determining how your lottery winnings will be treated, or you may suffer severe tax consequences. For example, in one case, a lottery winner entitled to receive his prize in annual installments agreed to turn over half of each annual installment to his ex-spouse, but did so in a way that left him liable for income tax on the entire amount of each installment. If you’re entitled to receive annual installments of a lottery prize over several years, it is possible that you’ll die before the end of the pay-out period. In that case, the “present value” of the unpaid installments will be part of your estate. This may cause your estate to be subject to estate tax, or may significantly increase the amount of estate tax due. But because these unpaid installments haven’t been paid yet, your estate might not have the cash to pay the tax on the includable amount. As usual, proper planning can avoid these problems.
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