Over the weekend, I pointed out the story of a fellow blogger who had raked in over $4,000 in rewards from a particularly generous credit card offer from his local bank.
The short version is that they offered him 10% cash back on grocery, drug store, and gas station purchases for 90 days and he ended up buying 100 x $500 Visa gift cards (over time).
Even after backing out the $4.95 activation fee per card, he cleared roughly $4500 in cash back rewards. Of course, this required having $50k on hand. But if you did, you could do a lot worse than $4500 in returning for time-shifting a bunch of purchases.
Income tax considerations
But what about the tax treatment of credit card rewards? Will his spoils be spoiled by the tax man? As it turns out, they won’t.
While the IRS hasn’t issued much in the way of public guidance on this issue, IRS Publication 17 does say this about cash rebates:
Cash rebates. A cash rebate you receive from a dealer or manufacturer of an item you buy is not income, but you must reduce your basis by the amount of the rebate.
Underlining added for emphasis. The bit about reducing your basis really only applies when calculating gains/losses if you sell the item or depreciation if used in business.
While the above relates to dealers and/or manufacturers, it’s not really a stretch to see how this might apply to rebates provided by a credit card company.
It’s also worth noting that the IRS issued a private letter ruling in 2002 that said certain credit card rebates are not considered to be taxable. While private letter rulings only applies to the taxpayers request them, they can give you a good indication of what the IRS is thinking.
But wait… What about the fact that Citi sent 1099 tax forms to certain credit card customers earlier this year in connection with their frequent flyer mileage earnings?
Well, industry experts (and even Citi themselves) agree that rewards given in connection with a purchase are not considered to be taxable income. You don’t pay taxes on coupon savings or mail-in-rebates, do you? Credit card rewards are similar.
The issue of taxability only arose in this case when people got large numbers of miles in return for opening their accounts (i.e., signup bonuses vs. traditional rewards) — though it’s worth noting that AmEx didn’t issue 1099s for such bonuses since there’s typically a minimum spending requirement attached.
When dealing with things like muni bonds, investors often tax about the tax equivalent yield of a certain holding. That is, how much an equivalent taxable investment would have to pay to equal the yield of the tax-exempt bond.
Here we can do something similar. The rewards aren’t taxable but, if he had earned the money in a more standard fashion — e.g., by working overtime or even as simple interest — it would have been taxable. So exactly how much ordinary income would he have to earn to equal $4500 in cash back rewards?
Assuming that he’s in the 25% federal tax bracket and pays ca. 6% in state taxes, then he’d have to gross a little over
$6500 $7300 [Updated: I forgot about Social Security!] to take home $4500 at the end of the day. If he was in a higher tax bracket — possible given that he had $50k cash on hand — then the tax-equivalent value would be higher.
So there you have it. Standard credit card rewards — whether they come in the form of points, miles, or cash — are widely considered to be non-taxable, whereas signup bonuses may (or may not) be taxable. And those tax-free earnings are worth even more when you consider the effects of taxes on ordinary income.