September 6, 2013

In 2012, a Citibank customer received a 1099 tax form informing him he was liable to pay $625 in taxes for the 25,000 American Airlines miles he had received as a “gift” for opening a checking and savings account package. Needless to say, he was shocked to find out that as far the the IRS was concerned his frequent flyer miles were taxable income. He and others in his situation complained.

However, Citibank was not to blame; the bank was simply following IRS taxation rules. This story was enough to send droves of clients running for cover from credit card rewards programs altogether out of fear of being hit with unexpected tax bills. Even respectable finance advice outlets overreacted to these stories and provided inaccurate and unhelpful advice on how the IRS taxes credit card reward points. This is sad. Customers who ignore credit card reward points are missing out on a great way of getting free cash just by being smart about how they pay for their everyday living expenses.

If, like me, you carefully collect credit card points throughout the year to finance the lion’s share of your vacation expenses, you may have wondered – or even worried — whether you should declare your hard-earned points when it comes to filing your tax return. Although the IRS could be clearer on how it treats credit card rewards, it has published information on the matter. So finding out your tax liability is just a matter of digging into the murky waters of IRS tax regulations publications. I know, you’ve got better things to do; but I don’t. So I did all the heavy reading for you. You’re welcome.

Nontaxable Discounts and Rebates Vs. Taxable Interest and Bribes

IRS Publication 17 provides a detailed breakdown of which sources of income are taxable and which are not. I’m afraid there are no surprises here. Pretty much every type of income you can think of is taxable. This includes unemployment benefits, life insurance proceeds, alimony, gambling earnings, lotteries, raffles and even bribes. Yes, the IRS publication actually says: “If you receive a bribe, include it in your income.”

Nevertheless, there are two sources of income the IRS does not tax: rebates and rewards. Not surprisingly, there is a caveat when it comes to rewards: “If you receive a reward for providing information, include it in your income.” So does that include credit card rewards or not? This lack of clarity is what has created the current confusion, which is why the IRS published a specific statement on frequent flyer miles and credit card points in their 2002-18 Announcement.

The statement provided the following clarification:

“The IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt of personal use of frequent flyer miles or other in-kind promotional benefits.” – IRS.gov

In classic IRS style the paragraph finishes with the tip “Any future guidance on the taxability of these benefits will be applied prospectively.” This means that, as of 2013, the IRS does not require you to declare the cash value of their credit card rewards and frequent flyer miles when you file your taxes; and even if they were to tax them in the future it will not be charged retroactively.

However, there is a big exception to this general rule when it comes to rewards you receive for making deposits or opening an account with a bank or other financial institution. In these cases the IRS considers the rewards as interest and therefore taxable. The IRS Publication 550 Investment Income and Expenses specifically says “for deposits of less than $5,000, gifts or services valued at more than $10 must be reported as interest. For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as interest.” This exception is what triggered the $625 tax bill for the Citibank customer mentioned at the outset.

The Bottom Line

In short, the IRS treats credit card rewards you earn when you purchase things, such as cash back, frequent flyer miles and points, as a reduction in the purchase price or as a rebate, which are not taxable. So you don’t have to worry about declaring your precious rewards as long as you don’t earn them by making a deposit (not a purchase) when opening an account.

One Last Caveat for Business Owners

The reason credit card rewards are not taxable income is because the IRS considers them a discount or price reduction, not as interest or as prize. Unfortunately, this also means you cannot claim as a business expense any item you buy or saving you receive with your credit card reward points. For instance, if a $2,000 business flight only costs you $1,000 after using your frequent flyer miles, you may only claim $1,000 toward travel expenses–not the full ticket value.

This article was written by staff writer Andrew Latham. His mission is to help fight your evil debt blob and get your personal finances in tip top shape.
Copyright © 2013 Andrew Latham
Photo: The-Lane-Team