You've been diligent about using the right credit cards for larger purchases to earn those cashback rewards and airline miles, but did you consider whether those freebies and rewards are taxable? By law, you're required to pay taxes on all types of income including lottery winnings, sweepstakes prizes, and other high-value goods received. Is cash earned from using a credit card, or airline miles you've racked up over the year, also considered to be a taxable item? Here's a closer look at the ins and outs of taxation on cashback rewards and airline miles:
Taxation of Credit Card Cashback Rewards. Whether you're using a personal credit card to earn rewards on high-end purchases or using a small business credit card to pay for business expenses, the IRS says credit card cashback rewards are not taxable--for the most part. Clarence Kehoe, executive partner of accounting firm Anchin, Block & Anchin, points out that in the eyes of the IRS credit card cashback rewards are considered to be a "purchase price reduction" instead of income. Just like any rebate offers you might be able to cash in for a large purchase, a cashback reward only deducts the price you paid for a particular item.
However, there may be situations where the IRS could see cashback rewards as income, says Kehoe. For example, if an employee was using their personal credit card to make business-related purchases and then was reimbursed by their employer --while earning rewards points or cash on their purchases--the IRS could see this as an abuse of the system if the individual was "earning" cash for tax avoidance purposes.
Kehoe says the IRS looks for abusive patterns when it comes to reporting income and business-related expenses. If you're a small business owner or are self-employed and are using a cashback credit rewards card to pay for inventory or business-related expenses, you will need to make sure you are reporting the reduction in your purchase price because of any cashback received. Not doing so may be a potential abuse of the system.
The Bottom Line: Credit card cashback rewards are not considered to be a taxable award or prize. However, a taxpayer would be responsible for reducing the amount of any deductions claimed for expenses paid using a rewards credit card for the amount of the cashback received.
Taxation of Airline Miles. If you've been busy collecting airline miles with all of those credit card purchases over the course of the year, the good news is that airline miles are tax-free. However, if you accepted frequent-flier miles as a bonus or award for opening an account with a partner company, you would be responsible for paying taxes on those miles because the IRS views them as taxable income.
In 2011, Citigroup's Citibank ran a special promotion to encourage people to sign up for a checking or savings account. The promotion involved awarding frequent flier miles to new customers signing up for an account. Customers who signed up ended up receiving 1099-MISC tax forms because they are responsible for paying 2.5 cents for every mile "earned" through the agreement. Two customers filed a federal lawsuit about this issue with Citibank. However, the IRS has not created any new guidelines about the taxation of frequent flier miles since 2002.
There are some instances where the IRS isn't enforcing tax collection on airline miles. According to the 2002 IRS announcement about taxation of frequent flier miles, "There are numerous technological and administrative issues relating to these benefits on which no official guidance has been provided, including issues related 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 fliers miles."
The Bottom Line: Even if the IRS is not enforcing taxation of this 'income,' that doesn't necessarily mean it shouldn't be reported. In the event airline miles were converted to any type of cash reward or benefit, they would have to be reported as taxable income. Receiving a 1099-MISC form may prompt many taxpayers to simply report the income on their tax returns so they can reduce the risk of being audited.
For more cash back credit card tips and financial advice from Sabah Karimi, check out personal finance blog Wise Bread.