Kentucky To Tax Prediction Markets

 

Something landed in my inbox about Kentucky HB 757.

So I am reading about prediction markets.

You have probably heard of these things: they are being used as an oracle of a sort. What are the odds that so-and-so will be elected to the political office of such-and-such in whatever state this fall? It is more than a poll, as people are wagering hard cash. I may tell a pollster just about anything to wrap-up the call, but I am certainly not parting with money.

I read that Kentucky will impose a 14.25% transaction tax on “event contracts” beginning January 1, 2027.

I get the concept of an “event contract.” It is a binary arrangement between two parties, with the contract resolving as either a “yes” or a “no.” To me the perfect example is a sports game: either the Reds will win or they will lose when they play the Mets on May 27. Bet your heart out accordingly.

I would have thought that these transactions were already being taxed.

Here is the point: they are not.

It is due to technology.

The sports betting you and I grew up with involved a house, a handle and the house establishing the odds. The key here is that the house (or DraftKings, FanDuel or whatever) received the bets, determined the handle and odds, paid-out the winners, and kept the difference (the “juice”).

The above is called “betting,” folks. It was taboo in major professional sports until the 2018 Supreme Court decision in Murphy v NCAA. Those of us who have been around for a moment remember the NFL barring Tony Romo from attending a fantasy football convention in Las Vegas, which act seems quaint today as gambling commercials blare at us on football Sundays. Fantasy was considered too close to betting, and sports betting would diminish the integrity of the game. Fast forward and the NFL started partnering with DraftKings and FanDuel in 2021.  Heck, they have probably had a baby by now.

The “new” sports betting is cribbing on territory belonging to futures contracts: both are considered derivatives and both are regulated by the Commodity Futures Trading Commission (CFTC).

Let’s say you and I bet on the May 27 Reds game.

Here is Robinhood:

This is easy: I will pay you 49 cents on the dollar that the Reds will win. If the Reds win. I win a dollar. If the Reds lose, I lose 49 cents. There will also be commissions and such, because … of course.

The fiction here is that you and I are not betting. We are instead “investing” in “financial instruments” subject to the CFTC. Granted, one of us will win and the other lose as the “event contracts” settle, but we are not “betting.” We are competing against each other on future events. We are not betting against a house, as that would describe a sportsbook. Nothing to see here, officer. Have a good day.

Hit somebody’s wallet and they will deny the very law of gravity.  

Almost 90% of these “financial instruments” are tied to sports betting.

This my shocked face: 

           

The effect of this is to remove the prediction markets from the routine and customary state gambling regulatory apparatus.

Which means that state taxes are taking a hit as money leaves their sportsbooks.

Enter Kentucky.

Since 2023 Kentucky has levied a 9.75% tax for on-track wagers and 14.25% for online and mobile wagers.  The last time I checked, the horse racing industry was contributing upwards of $200 million annually to state tax revenue. You can bet your bippy Kentucky is going to protect it.

The new 14.25% tax on prediction markets is the same as for other online betting.

And the tax will apply whether one bets via DraftKings or DraftKings Predictions. Or FanDuel or FanDuel Predicts.

Yep, same companies but two platforms.

This is new frontier in state taxation, and you can be certain there will be litigation before the matter is settled.  I suspect this will go to the Supreme Court eventually.

The issue affects all states, of course. We limited our discussion today to Kentucky for one nontechnical reason: I live here.

 

The Gallenstein Rule

 

It is a tax rule that will eventually go extinct.

It came to my attention recently that it can – however – still apply.

Let’s set it up.

(1)  You have a married couple.

(2)  The couple purchased real estate (say a residence) prior to 1977.

(3)  One spouse passes away.

(4)  The surviving spouse is now selling the residence.

Yeah, that 1977 date is going to eliminate most people.

We are talking Section 2040(b).

(b)  Certain joint interests of husband and wife.

(1)  Interests of spouse excluded from gross estate.

Notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest.

(2)  Qualified joint interest defined.

For purposes of paragraph (1), the term "qualified joint interest" means any interest in property held by the decedent and the decedent's spouse as-

(A)  tenants by the entirety, or

(B)  joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants.

In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr. G provided all the funds for the purchase. They owned the property as joint tenants with right of survivorship.

In 1987 Mr. G died.  

In 1988 Mrs. G sold 73 acres for $3.6 million. She calculated her basis in the land to be $103,000, meaning that she paid tax on gain of $3.5 million.

Someone pointed out to her that the $103,000 basis seemed low. There should have been a step-up in the land basis when her husband died. Since he owned one-half, one-half of the land should have received a step-up.

COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later.  Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.

Someone looked into Mrs. G’s situation and agreed. In May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8 million. Since the basis went up, the taxable gain went down. She was entitled to a refund.

Three months later she filed a second amended return showing basis in the land as $3.6 million. She wanted another refund.

This time she caught the attention of the IRS. They could understand the first amended but not the second. Where were these numbers parachuting from?

I am going to spare us both a technical walkthrough through the history of Code section 2040.

There was a time when joint owners had to track their separate contributions to the purchase of property, meaning that each owner would have his/her own basis. I suppose there are some tax metaphysics at play here, but the rule did not work well in real life. Sales transactions often occur decades after the purchase, and people do not magically know that they need to start precise accounting as soon as they buy property together. Realistically, these numbers sometimes cannot be recreated decades after the fact. In 1976 Congress changed the rule, saying: forget tracking for joint interests created after 1976. From now on the Code will assume that each tenant contributed one-half.

That is how we get to today’s rule that one-half of a couple’s property is included in the estate of the first-to-die. By being included in an estate, the property is entitled to a step-up in basis. The surviving spouse gets a step-up in the inherited half of the property. The surviving spouse also keeps his/her “old” basis in his/her original one-half. The surviving spouse’s total basis is therefore the sum of the “old” basis plus the step-up basis.

Mr. G died before 1977.

Meaning that Mrs. G was not subject to the new rule.

She was subject to the old rule. Since Mr. G had put up all the money, all the property (yes, 100%) was subject to a step-up in basis when Mr. G died.

That was the reason for the second amended return.

The Court agreed with Mrs. G.

It was a quirk in tax law.

The IRS initially disagreed with the decision, but it finally capitulated in 2001 after losing in court numerous times.

Mind you, the quirk still exists. However, the population it might affect is dwindling, as this law change was 47 years ago. We only live for so long.

However, if you come across someone who owned property with a spouse before 1977, you might have something.

BTW this tax treatment has come to be known by the widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein rule.”

ProShares Bitcoin ETF and Futures Taxation

 

This week something happened that made me think of a friend who passed away last year.

I remember him laboring me on the benefits of CBD oil and the need to invest in Bitcoin.

When he and I last left it (before COVID last year), Bitcoin was around $10 grand. It is over $60 grand presently.

Missed the boat and the harbor on that one.

This past week ProShares came out with a Bitcoin ETF (BITO). I read that it tripped the billion-dollar mark after two or three days of trading.

With that level of market acceptance, I suspect we will see a number of these in the near future.

This ETF does not hold Bitcoin itself (whatever that means). It instead will hold futures in Bitcoin.

Let’s talk about the taxation of futures.

First, what are futures and what purpose do they serve?

Let’s say that you are The Hershey Company and you want to lock-in prices for next year’s cacao and sugar. These commodities are a significant part of your costs of production, and you want to have some control over the price you will pay. You are a buyer of futures commodity contracts – in cacao and sugar – locking in volume, price and date of delivery.

Whereas you do not own the cacao and sugar yet, if their price goes up, you would have made a profit on the contract. The reverse is true, of course, if the price goes down. Granted, the price swing on the futures contract will likely be different than the swing in spot price for the commodity, as there is the element of time in the contract.  

That said, there is always someone looking to make a profit. Problem: if commodity traders had to actually receive or deliver the commodity, few people would do it. Solution: separate the contract from actual product delivery.  The contract can then be bought and sold until the delivery date; the buyers and sellers just settle-up any price swings between them upon sale.

It would be also nice to have a market that coordinates these trades. There are several, including the Chicago Mercantile Exchange. The Exchange allows the contracts to be standardized, which in turn allows traders to buy and sell them without any intent to ever receive or deliver the underlying commodity.

The ETF we are discussing (BITO) will not own any Bitcoin itself. It will instead buy and sell futures contracts in Bitcoin.

Bitcoin futures are considered “Section 1256 contracts” in tax law.

Section 1256 brings its own idiosyncrasies:

* There is a mark-to-market rule.

The term “mark” to an accountant means that something is reset to its market price. In the context of BITO, it means that – if you own it at year-end – it will be considered to have been sold. Mind you, it was not actually sold, but there will be a “let’s pretend” calculation of gain or loss as if it had been sold. Why would you care? You would care if the price went up and you had a taxable gain. You will soon be writing a very real check to the IRS for that “let’s pretend” mark.

* The 60/40 rule

This rule is nonintuitive. Whether you have capital gains or losses, those gains and losses are deemed to 60% long-term and 40% short term. The tax Code (with exceptions we will ignore for this discussion) does not care how long you actually owned the contracts. Whether one day or two years, the gain or loss will be deemed 60/40.

Mind you, this is not necessarily a bad result as long-term capital gains have favorable tax rates.

* Special carryback rule

If you have an overall Section 1256 loss for the year, you can carryback that loss to the preceding three years. There is a restriction, though: the carryback can only offset Section 1256 gains in those prior years.

This is a narrow rule, by the way. I do not remember ever seeing this carryback, and I have been in tax practice for over 35 years.

I do not know but I anticipate that BITO will be sending out Schedules K-1 rather than 1099s to its investors, as these ETFs tend to be structured as limited partnerships. That does not overly concern me, but some accountants are wary as the K-1s can be trickier to handle and sometimes present undesired state tax considerations.

Similar to my response to Bitcoin investing in early 2020, I will likely pass on this opportunity. There are unusual considerations in futures trading – google “contango” and “backwardation” for example – that you may want to look into when considering the investment.

TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

An Extreme Way To Deduct Expenses Twice

The estate tax is different from the income tax.

The latter is assessed on your income. This puts stress in defining what is income from what is not, but such is the concept.

The estate tax on assessed on what you own when you die, which is why it is also referred to as the “death” tax. If you try to give away your assets to avoid the death tax, the gift tax will step in and probably put you back in the same spot.

Granted, a tax is a tax, meaning that someone is taking your money. To a great extent, the estate tax and income tax stay out of each other’s way.

With some exceptions.

And a recent case reminds us of unexpected outcomes when these two taxes intersect.

Let’s set it up.

You may recall that – upon death – one’s assets pass to one’s beneficiaries at fair market value (FMV). This is also called the “step up,” as the deceased’s cost or basis in the asset goes away and you (as beneficiary) can use FMV as your new “basis” in the asset. There are reasons for this:

(1) The deceased already paid tax on the income used to buy the asset in the first place.

(2) The deceased is paying tax again for having died with “too many” assets, with the government deciding the definition of “too many.” It wasn’t that long ago that the government thought $600,000 was too much. Think about that for a moment.

(3) To continue using the decedent’s back-in-time cost as the beneficiary’s basis is to repetitively tax the same money. To camouflage this by saying that income tax is different from estate tax is farcical: tax is tax.

I personally have one more reason:

(4) Sometimes cost information does not exist, as that knowledge went to the grave with the deceased. Decades go by; no one knows when or how the deceased acquired the asset; government and other records are not updated or transferred to new archive platforms which allow one to research. The politics of envy does not replace the fact that sometimes simply one cannot come up with this number.

Mr. Backemeyer was a farmer. In 2010 he purchased seed, chemicals, fertilizer and fuel and deducted them on his 2010 joint return.

COMMENT: Farmers have some unique tax goodies in the Code. For example, a farmer is allowed to deduct the above expenses, even if he/she buys them at the end of the year with the intent to use them the following year. This is a loosening of the “nonincidental supplies” rule, which generally holds up the tax deduction until one actually uses the supplies.

So Mr. Backemeyer deducted the above. They totaled approximately $235,000.

He died in March, 2011.

Let’s go to our estate tax rule:

His beneficiary (his wife) receives a new basis in the supplies. That basis is fair market value at Mr. Backemeyer’s date of death ($235,000).

What does that mean?

Mr. Backemeyer deducted his year-end farming supplies in 2010. In tax-speak,” his basis was zero (-0-), because he deducted the cost in 2010. Generally speaking, once you deduct something your basis in said something is zero.

Go on.

His basis in the farming supplies was zero. Her basis in the farming supplies was $235,000. Now witness the power of this fully armed and operational step-up.

Is that a Rogue One allusion?

No, it is Return of the Jedi. Shheeessh.

Anyway, with her new basis, Mrs. Backemeyer deducted the same $235,000 again on her 2011 income tax return.

No way. There has to be a rule.

          That is what the IRS thought.

There is a doctrine in the tax Code called “economic benefit.” What sets it up is that you deduct something – say your state taxes. In a later year, you get repaid some of the money that you deducted – say a tax refund. The IRS takes the position – understandably – that some of that refund is income. The amount of income is equal to a corresponding portion of the deduction from the previous year. You received an economic benefit by deducting, and now you have to repay that benefit.

It is a great argument, except for one thing. What happened in Backemeyer was not an income tax deduction bouncing back. No, what set it up was an estate tax bouncing back on an income tax return in a subsequent year.

COMMENT: She received a new basis pursuant to estate tax rules. While there was an income tax consequence, its origin was not in the income tax.

The Court reminded the IRS of this distinction. The economic benefit concept was not designed to stretch that far. The Court explained it as follows:

(1) He deducted something in 2010.

(2) She deducted the same something in 2011.

(3) Had he died in 2010, would the two have cancelled each other out?

To which the Court said no. If he had died in 2010, he would have deducted the supplies; the estate tax rule would have kicked-in; her basis would have reset to FMV; and she could have deducted the supplies again.

It is a crazy answer but the right answer.

Is it a loophole? 

Some loophole. I do not consider tax planning that involves dying to be a likely candidate for abuse.