Let me start off by stating that I’m am NOT a tax expert or certified in any way to consult on your personal or business taxes. My plan with this post is to go through the different statements the IRS has made on the taxation of miles, points, and cash back and how this may impact the amount you report to the government on your taxes. One popular statement is that cash back (and miles/points) is counted as a rebate and therefore you don’t have to worry about them when it comes to taxes. While that statement applies to the overwhelming majority of credit card users, anyone who is reselling items purchased on credit cards for points and profit may need to double-check their math. Even if you choose not to participate in the reselling of gift cards, merchandise, and more, the more traditional methods of manufacturing spend may have more tax impact than you’re aware of. I’ll cover all of that and more by helping you calculate whether or not you’re actually earning income as you chase free travel via credit cards, shopping portals, and more.
The IRS’s Stance on Credit Card Rewards
The IRS has been pretty tight lipped on exactly how they treat credit card rewards, but this may actually work to your advantage as you stay in the “grey area”. The only official statement I could find on the subject is from a 2002 announcement that discusses frequent flyer miles (IRS letter (PDF) from 2002). Here is an excerpt, but the letter is short, so I recommend you read the whole thing:
Consistent with prior practice, the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel. Any future guidance on the taxability of these benefits will be applied prospectively.
This relief does not apply to travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes.
The primary purpose of this letter seems to focus on tax liability of miles, upgrades, and other travel benefits, with a special focus on those earned during business travel. The IRS’s stance was that none of these travel benefits would be subject-able to tax UNLESS they were converted to cash. The last paragraph specifically calls out that this “relief” does NOT apply to cash benefits.
Aside from that vague letter in 2002, the IRS hasn’t taken an official stand on credit card rewards. As most of you know, this provides a little flexibility on the classification of the earned rewards and therefore we can treat all of the rewards as discounts (or rebates) on the item purchased to earn them. Turbo Tax has a nice article explaining how this discount works and why it is treated differently from a cash prize.
What It Means For The Average Consumer
For most people, classifying all credit card rewards (cash or points) as rebates simplifies things to the point where they never have to worry about it. Everything they buy for themselves that earns points or cash back (from credit cards, shopping portals, or even mail-in-rebates) is simply cheaper than the sticker price they paid as far as the IRS is concerned. This means there is nothing to report come tax time and everything remains simple for the person earning all of the rewards on their purchase. Let’s walk through an example to hopefully drive the point home:
Let’s say I purchase a $1000 laptop computer from Staples. I’ll use a simple 2% cash back card and earn $20 back on the purchase. In addition, I went through a 5% cash back shopping portal and earned an additional $50 that way. Also, I’m also a part of Staples Rewards, and I earned an additional 5% back or another $50 from that. (As the Staples Rewards isn’t “cash”, we fall into a grey area as far as taxes are concerned, but for this example, let’s treat it like cash.)
At the end of the day, I bought a $1,000 laptop and earned $120 back in “cash” rewards. At first you might think I’ll have to pay taxes on the $120 because it could be considered “income”, but as I explained above, these rewards are considered “rebates” instead of “income”. For that reason, as far as the IRS and taxes are concerned, I purchased the laptop for $880 and there’s nothing more to consider.
Why Reselling Complicates Things
For the average consumer, all they really need to know is that points, miles, and cash back earned from credit cards and more, do NOT count as income, and they don’t even need to think about it when filling out taxes. Anyone who buys things to resell on the other hand (merchandise, gift cards, or anything else), has a lot more to consider. The most important consideration with reselling and taxes is whether or not you make a “profit”. While calculating profit may seem straightforward, once you take into account all the rewards, portals, and rebates on each item, the math gets a little trickier. While this may not be a concern for big businesses who typically don’t buy things with credit cards, any small business owner or hobbyist reseller using them has to take it into account.
Let’s look at the same example from above, but from a reselling perspective. Let’s say I purchased the same $1,000 laptop and earned $120 back in cash rewards, but then sold the laptop for $950. At first, you might calculate a “profit” of -$50 (negative $50) by subtracting the $950 sell price from the $1,000 buy price, but that is NOT the proper way to calculate profit. Instead, you must take into account the “rebates” on the buy price and actually reduce the original $1,000 to $880 (by subtracting the $120 in cash rewards). This makes the new profit calculation $950 minus $880 for a profit of $70.
I imagine this math is the same as what resellers are doing to determine if a deal is worth pursuing, but it’s important to note that the IRS is doing the same math when it comes to earned income. The $70 in profit earned in the above example just became earned income and the IRS is expecting you to account for it on your taxes and pay according to whatever tax bracket you may fall in. If you weren’t taking these taxes into account before you jumped into the reselling game, it might be a good time to review everything you’ve sold so far and possibly set some money aside for taxes at the end of the year if your profit was significant.
The Miles and Points Grey Area
While the IRS has a pretty clear precedent when it comes to cash back and benefits that are “converted to cash”, they do NOT have official language on the implication of earned points and miles. This excerpt from the IRS statement above pretty much explains why:
There are numerous technical and administrative issues relating to these benefits on which no official guidance has been provided, including issues relating to the timing and valuation of income inclusions and the basis for identifying personal use benefits attributable to business (or official) expenditures versus those attributable to personal expenditures. Because of these unresolved issues, the IRS has not pursued a tax enforcement program with respect to promotional benefits such as frequent flyer miles.
Back in 2012, Citi issued 1099’s (IRS Misc Income Form) to people that participated in a bank promotion which awarded 25,000 American Airlines miles. Citi decided to value that 25k award at $645 or just over 2.5 cents per mile! Many people were upset and even several tax experts weren’t sure what to make of it. The forms resulted in some kind of lawsuit against Citi, but I was unable to find any details about a resolution (UPDATE: The lawsuit was settled). The IRS only stated that the 2002 letter still stands and haven’t made any clarifications beyond that since. As far as I know, Citi no longer sends out 1099’s for awarding miles and points, but they do include language in the terms and conditions that imply it’s possible.
It’s understandable why the IRS hasn’t taken an official stance on points and miles, because several problems would crop up if they did. Firstly, points and miles aren’t technically owned by the person who’s account they are in, but instead are owned by the provider of the program (whether that be an airline, hotel, or bank). It’s hard to consider something as income if the person receiving that “income” doesn’t even own it and it could be taken away at any time. Secondly, how would you place a value on the many different kinds of points and miles? Even among “experts” in the points and miles game there isn’t anything close to a consensus on the actual value of a point or mile because the value varies so drastically depending on when, where, and how they are used.
While this may seem like a huge mess, the grey area when it comes to miles and points can actually be used to your advantage. Let’s revisit the same laptop example above. Instead of using a 2% cashback card, let’s say I use something that earned 5 “points” per dollar. In addition, I will also use a shopping portal that rewards 5 “miles” per dollar instead of 5% cash back. The Staples Rewards stay the same (but it still a cash-equivalent grey area).
Now we’ve purchased a laptop for $1,000 and earned 5000 “points”, 5000 “miles”, and $50 in “cash”. Assuming we sell it for the same $950, the profit calculation comes out to $950 (buy price of $1,000 minus $50 “cash” rebate) minus $950 (sell price) for a profit of $0! As far as the IRS is concerned, you broke even on the deal and have no extra earned income or tax liability.
As I stated at the top, I’m not a tax expert and you should consult a professional when it comes to calculating your tax liability. Having said that, everything I can find on the subject suggests miles and points carry no value in the IRS’s eyes so long as they aren’t “converted to cash”. I leave the interpretation of “converted to cash” up to you and your tax professional.
Balancing the Books
Whether you treat reselling as a business or a hobby, it’s important to keep track of your profit over the course of a year. While you may make $70 in profit reselling one item, maybe you lost $50 on a different one (even if you did earn oodles of “worthless” points in the process 😉 ). Once again, consult an expert before taking my word as gospel, but you should be able to calculate your “profit” for the year across reselling as a whole, and essentially deduct all of the losses from the wins and only pay taxes on the final profit you come up with. Every time you take a loss on paper from either a deal gone wrong or one that involved lots of “points”, this should reduce your tax burden on the deals that had a cash profit. A careful balance of both points and cash back may be in your best interest to either reduce or eliminate you tax obligation altogether.
What About Traditional MS?
When I say traditional MS (manufactured spend), I am primarily referring to the act of buying visa/mastercard/amex gift cards with a credit card and then converting them back into cash via loadable prepaid cards or money orders. While the practice may not involve buying and selling in the traditional sense, the IRS will definitely care if you’re walking away with more money than you put in. I always thing of Al Capone when I read discussions of whether or not MS profits are taxable. Despite Capone obtaining all of his money from illegal activities, the only thing they could convict him for was tax evasion. The moral of that story is that no matter where your money is coming from or how you obtained it, you better be ready to pay taxes on the full amount, the IRS doesn’t discriminate by source of income.
So let’s look at traditional MS and see if there’s actually a “profit” being made in regards to taxes. There’s obviously a “profit” in the eyes of the people participating because otherwise there would be no point in doing so, BUT with the miles and points grey area, it’s possible the IRS doesn’t recognize any actual profit. Let’s try to calculate the “profit” that matters at tax time:
First example: I use a credit card that earns 5 “points” at Staples to by a $200 Visa gift card. The cost of the $200 card is $206.95 because of fees. After purchasing, let’s simplify and say I deposit the $200 directly into my bank account and the overall transaction is complete. There’s no reason we can’t look at this like a reselling opportunity, so we calculate the profit as sell price ($200) minus buy price ($206.95) for a final profit of negative $6.95. So long as you don’t convert the 1,035 points earned to cash, they have no value and the overall transaction has no tax liability.
Second example: I use a credit card that earns 6% cash back at a grocery store to buy a $500 Visa gift card. The cost is $505.95 because of fees and the credit card earnings will be $30.36 in cash back. For simplicity, let’s say we deposit the $500 directly into a checking account. The profit calculation for this example is sell price ($500) minus buy price ($505.95 minus the $30.36 “rebate” or $475.59) for a profit of $24.41. As far as the IRS is concerned, you made $24.41 in earned income on this particular transaction and are obligated to report it as miscellaneous income and pay taxes on it.
Third example: Let’s say you did the first example 10 times (total profit of negative $69.5) and the second example twice (total profit of $48.82). Despite making money on the grocery store puchases, by grouping together all of your MS activity when calculating profit, your tax liability should still be zero because overall you lost money at far as the IRS is concerned. Once again, consult a professional for your own personal situation.
Overall, we learned that the IRS has an easy to understand way of looking at cash back rewards and treats them as discounts on the purchase price. We also learned that the IRS has nothing resembling a solid stance on the matter of points and miles earned through the same methods. Luckily, for the average consumer they won’t have to worry about these implications and have no tax impact. On the other hand, anyone reselling or MSing with these “discounts” needs to factor that in when calculating profit and taxable income. It may make more sense to focus on points and miles for at least part of your overall plan in order to reduce or eliminate your tax obligation as you chase free travel. And simply because it can’t be said enough, please consult a tax professional when figuring out your own personal tax situation. I don’t want a bunch of angry emails if/when you get audited following the information I laid out here.