Prediction Markets and Taxes: The IRS Hasn't Figured This Out Yet, But You Still Owe

Prediction markets have exploded. Platforms like Kalshi, Polymarket, and now Robinhood, Coinbase, DraftKings, and Interactive Brokers are letting millions of users trade binary contracts on everything from Fed rate decisions to geopolitical events. Monthly trading volume is now measured in billions, and one consulting firm estimates the market could hit $1 trillion by the end of the decade. But here's the problem: the IRS has issued zero formal guidance on how any of this should be taxed. No Revenue Ruling. No Private Letter Ruling. No FAQ. Nothing. As of March 2026, every prediction market participant in America is essentially making it up as they go, and three reasonable tax professionals looking at the same set of trades could reach three completely different conclusions about what goes on the return.

That's not an exaggeration. There are currently three defensible approaches to reporting prediction market income, and they produce dramatically different tax results.

The first approach treats prediction market contracts as Section 1256 contracts under the Internal Revenue Code. If a contract qualifies under Section 1256, all gains and losses receive a blended 60/40 treatment — 60 percent taxed as long-term capital gains and 40 percent as short-term — regardless of how long you held the position. For a trader in the 37 percent bracket, this blended rate works out to roughly 26.8 percent, which is a significant savings compared to ordinary income rates. The argument for Section 1256 treatment is strongest for Kalshi, which operates as a CFTC-regulated Designated Contract Market. But Section 1256 is a statutory override with specific definitional requirements, and whether binary event contracts on outcomes like "Will it rain in Des Moines?" actually fit the statutory categories of "regulated futures contracts" is genuinely unsettled. The IRS has historically taken a narrow view of what qualifies under Section 1256, and without explicit guidance confirming that event contracts are covered, taking this position carries real audit risk.

The second approach treats the activity as gambling. Under this characterization, all winnings are ordinary income reported on Schedule 1, and losses are deductible only if you itemize — and only to the extent of your winnings. Here's where a major change kicks in for 2026: the One Big Beautiful Bill Act capped the gambling loss deduction at 90 percent of losses, down from the prior 100 percent. This means that a prediction market trader who treats the activity as gambling and has $200,000 in winnings and $200,000 in losses — a break-even year — would have $20,000 in phantom taxable income because they can only deduct $180,000 of their $200,000 in losses. That's a tax bill on money you never actually made. This is a new trap that didn't exist before 2026, and it's going to catch a lot of casual traders off guard.

The third approach treats the contracts as ordinary capital assets — property held by the taxpayer — with gains and losses reported on Form 8949 and Schedule D. Under this treatment, you can net gains against losses without the gambling loss limitation, and positions held longer than a year qualify for long-term capital gains rates. The downside is that most prediction market positions resolve in days or weeks, meaning most gains would be short-term and taxed at ordinary rates anyway. But the ability to net losses fully against gains, without the 90 percent cap, makes this approach significantly more favorable than gambling treatment for active traders.

The reporting burden falls entirely on you. Kalshi issues a 1099-INT for interest on cash balances and a 1099-MISC for referral bonuses, but it does not issue a standard 1099-B for event contract trades. Robinhood explicitly states it will not provide 1099s for event contract trades. Polymarket, operating as an offshore Panama entity on the Polygon blockchain, issues no tax forms of any kind. This means you need to track every contract purchase, every sale, and every resolution yourself, calculate your basis and proceeds, and report the activity under whichever characterization you and your tax advisor determine is most defensible.

For Polymarket traders specifically, there's an additional layer of complexity that gets almost no attention: every trade is a cryptocurrency transaction. Positions are denominated in USDC, a dollar-pegged stablecoin, and each contract purchase, sale, and settlement is a taxable disposition of the cryptocurrency itself under current IRS crypto reporting rules. This means a single prediction market trade on Polymarket can generate two taxable events — one from the event contract and one from the crypto movement. If you made dozens or hundreds of trades across multiple markets in 2025, you could be looking at a Form 8949 with hundreds of line items, each requiring separate basis tracking. And because everything is on-chain, the IRS can audit the entire ledger at any time.

The platform-versus-gambling regulatory fight happening at the state level adds another dimension. Kalshi is currently involved in more than a dozen lawsuits with state governments over whether prediction markets constitute gambling subject to state gaming commissions or futures contracts regulated by the CFTC. A coalition of 39 state attorneys general plus the District of Columbia has filed amicus briefs against Kalshi. Nine states have issued cease-and-desist letters. Massachusetts obtained a preliminary injunction in January 2026 that is currently stayed on appeal. How this regulatory fight resolves could have direct tax implications: if prediction market contracts are ultimately classified as gambling at the state level, the IRS will have strong ammunition to assert gambling treatment at the federal level as well.

From a practical standpoint, most tax professionals are currently advising clients to report prediction market income as "Other Income" on Schedule 1, Line 8z, with a description like "Prediction market earnings." This is the most conservative approach and the least likely to be challenged on audit. It's also the most expensive from a tax perspective. For high-volume traders with significant net gains, the Section 1256 argument is worth exploring, but only with the support of a written opinion from a tax attorney — the kind of documentation that supports a reasonable cause defense if the IRS disagrees. Taking the Section 1256 position without professional advice and documentation is inviting a negligence penalty on top of the additional tax if the IRS reclassifies the income.

The bottom line is this: the IRS hasn't told you how to report prediction market income, but it absolutely expects you to report it. The fact that no one sends you a 1099 doesn't mean the IRS doesn't know about your trading — blockchain transactions are permanently recorded and auditable, and CFTC-regulated platforms maintain detailed records of every trade. If you're actively trading on these platforms, get a tax professional involved now, before filing season, and make a deliberate, documented choice about how to characterize the activity. The worst position to be in is having reported nothing and hoping nobody notices.

State taxes add yet another dimension that most traders ignore entirely. Some states follow federal characterization, meaning however you report it federally is how it's treated at the state level. Others have their own rules. New Jersey, for example, allows 100 percent gambling loss netting on the state return regardless of the federal 90 percent cap — a meaningful advantage for New Jersey residents who treat the activity as gambling. Texas has no state income tax, which simplifies the analysis for Houston-based traders, but if you're trading from a state with income tax, the state-level treatment could be a separate issue entirely. And for Polymarket traders using an offshore platform with cryptocurrency settlement, FBAR and FATCA reporting obligations may apply if the value of your foreign financial accounts exceeds the applicable thresholds.

One more practical point: if you've been trading prediction markets and you report conservatively now — as ordinary income — and the IRS later clarifies that Section 1256 treatment applies, you can file an amended return and claim a refund of the overpayment. The reverse is much worse. If you report aggressively under Section 1256 and the IRS later determines that gambling treatment applies, you'll owe the difference plus interest plus potential penalties. In a landscape with zero guidance and three defensible positions, conservative reporting with thorough documentation is the only approach that doesn't carry downside risk.