Credit Card Hackers Beware: IRS Deems Reward Dollars Taxable Income

Developing financial literacy, and the pursuit of financial independence, tends to generate extreme enthusiasm among participants. People go big.

Folks who stumble across the Mr. Money Mustache blog don't just take note of MMM's frugal lifestyle, they tend to judge whether they are following the precepts of Mustachianism, a tongue in cheek term for a cult that is more serious than adherents might care to admit.

In a similar vein, many FIRE enthusiasts seem to discover and wholeheartedly embrace credit card point-earning strategies as a means of subsidizing air travel, hotel stays, and even obtaining cash back.

Pre-COVID, it was a rite of passage to share with friends how an elaborate trip was paid for courtesy of sign up bonuses from a Chase Sapphire card, or how many free flights one's partner had enjoyed using the Southwest Companion Pass.

In some cases, in order to rack up credit card points, strategic consumers devised a manufactured spend where credit cards were used to purchase coins or gift cards which were never used to purchase actual merchandise - simply to churn more points for the client.

One famous version of this was a promotion by the U.S. Mint intended to introduce new one dollar coins into circulation. The Mint shipped the coins for free to anyone who purchased them, and savvy credit card hackers purchased thousands of dollars worth of coins to meet minimum spends that scored them large credit point bonuses, only to deposit those coins into their bank accounts.

Those early loophole spotters look like rank amateurs compared to the exploits of the Anikeevs, a couple who over the course of 2013 charged $1.2 million to their Blue Cash from American Express card, redeeming an impressive $36,200 in rewards dollars credited to their statement.

Mr. Anikeev, who earned a doctorate in physics from MIT, used his quant skills to identify unintended loopholes in a promotion where American Express offered 5% cash back per year after an initial $6500 spend on all "everyday purchases," defined as what can be bought at supermarkets, gas stations and drugstores.

Since these businesses sell gift cards, reloadable debit cards, and money orders, the couple purchased these items in extreme quantities, then subsequently deposited the funds to their bank accounts.

Apparently not a "moderation in all things" kind of couple, the Anikeevs charged $5.18 million to their card the following year. They redeemed $277,275 in statement credits in 2014.

Here's where things took a turn from a Gordon Gecko, "greed is good" attaboy to a cautionary tale for overly zealous credit card hackers.

The IRS sued the Anikeevs in Tax Court, claiming their rewards dollars statement credits constituted taxable income.

Based on prior case law, when an individual uses a credit card rewards program, the federal government regards it as an inducement to purchase goods or property, thus the cash back or points are considered a form of purchase price adjustment to the basis of the property (a complicated form of discount).

Since the Anikeevs were buying cash equivalents only to deposit the cash in their bank accounts, and never actually purchased goods or property, the IRS argued they owed taxes on their cash back rewards.

The Tax Court judge agreed, ruling in favor of the IRS.

[Things I never expected to type:] You can read the surprisingly fascinating details of the Tax Court opinion through a link in this summary from the accounting firm KPMG. Look for the pdf link near the top of the article.

This is the credit card hacker's equivalent of the tax shot heard round the world.

In a different life, I'm starting to think I might have been an accountant...