March Madness is in the air. That means that in addition to watching televised National Collegiate Athletic Association basketball games and tracking online scores, a lot of folks are keeping a close eye on the betting lines.

True, unless you’re in Nevada, putting a few bucks on NCAA basketball championship games is illegal. That technicality, however, doesn’t stop avid roundball fans and inveterate bettors. For U.S. gamblers, the annual college basketball tournament is second only to the Super Bowl.

Many bets are just friendly wagers — a dollar in the office pool or a good-natured bet with that neighbor who’s a North Carolina graduate.

But other basketball fans take the games more seriously and hand over big bucks to bookmakers, legal and not-so-legal.

Nevada is the only state in which legal sports bets can be placed. The Nevada Gaming Commission estimates March Madness wagering will be around $90 million. But you can be sure that much or more will be wagered illegally.

All this betting interest prompted the NCAA to send representatives to meet with sports-book operators in Las Vegas to watch for suspicious wagering patterns as the tournament began last month.

Another group also is carefully watching the NCAA betting action: the Internal Revenue Service. All these sports wagers spotlight the persistent problem that the agency faces in tracking and taxing gambling winnings. It’s a challenge the agency faces daily because many people don’t realize that gambling winnings, even the illegal payouts, are taxable. Of those who do know, a good portion simply choose to ignore the tax law.

Admittedly, the IRS is playing catch-up here. While the U.S. income tax is a 19th century creation, gambling has been around at least since man was able to record his activities. Dice almost identical to those used on today’s gaming tables have been recovered from Egyptian tombs, and the Chinese, Japanese, Greeks and Romans all were known to play games of chance as early as 2300 B.C.

Nowadays, in addition to the well-publicized offerings of Las Vegas, Reno and Atlantic City, betting is commonplace throughout the United States. The choices range from off-track betting parlors to tribal bingo games to riverboat casinos to state-operated lotteries.

Online gambling down, but not out

Then there’s online gambling. A decade ago, The Washington Post reported “at least 140 Web sites now offer some form of wagering to online users — an expansion in recent years that has alarmed opponents and put increased focus on the laws that govern Internet gambling.” By 2005, research firm Christiansen Capital Advisors estimated that nearly 23 million people gambled on the Internet, with approximately 8 million of those gamblers from the United States.

It’s easy to see why the numbers have grown so much. Type “online gambling” into any Internet search engine and within seconds you’ll have a list of hundreds of thousands of potential gambling sites. This is in spite of the Unlawful Internet Gambling Enforcement Act, which was passed without much fanfare and signed into law in late 2006 in an effort to restrict U.S. gamblers’ access to these typically foreign-based Web sites. It is now a federal crime for U.S. banks and credit card companies to process Internet-bet payments.

Some companies have curtailed their U.S. betting operations, but in reality, the law has had little effect. And in the global arena, America is coming up short. The World Trade Organization, or WTO, has ruled against the United States in a dispute over Internet gambling operations based in Antigua.

“America’s prohibition in the provision of gambling services from other countries violates the U.S. commitments to the WTO,” says the Caribbean island’s representative Mark Mendel. Because the 2006 law allows online wagers on horse and dog racing, Antigua successfully argued that the statute unfairly forbids international companies from competing in the U.S. market.

In a recent interview with the online gambling portal MajorWager.com, Mendel indicated that a compromise which could open some online gambling markets in the U.S., while not granting full access, may be a possible solution.

Will U.S. lawmakers eventually soften their stance on online gambling? Maybe. And it may be the sheer numbers that change minds.

A recent study by accounting giant PricewaterhouseCoopers found that the United States could raise $52 billion over the next decade if it lifted the country’s ban on Internet gambling and taxed the activity instead. The accounting firm says the amount of money to be made now is about 22 percent higher than it was in 2007, indicating that U.S. online gambling has grown despite the ban.

The accounting firm’s study was done specifically for UC Group, an online payment service company that would benefit from U.S. action to legalize Internet gambling. However, the amount of potential tax revenue in this economy surely will spark some second looks at the ban.

Meanwhile, online gambling sites and their cyberpatrons are adapting. All online gambling operations now carry a disclaimer alerting visitors that although a wagering site may be operating legally at its location, it may still be illegal for the patron to wager from his or her location.

To get around payment hurdles, some sites have introduced dedicated debit cards and the alternative, although circuitous, e-payment and electronic wallet services. It’s a good bet that millions of U.S. customers will be utilizing them as the NCAA Final Four battle this weekend to go to Monday’s championship game.

So many events, so many bets

Combine all these gambling options with Americans’ love of athletics, and betting on sporting events has arguably become the true national pastime. If you want to keep your sports wagering domestic, legal betting on athletic events is allowed only in Nevada.

States with gaming
Commercial casinos Colorado, Illinois, Indiana, Iowa, Louisiana, Michigan, Mississippi, Missouri, Nevada, New Jersey, Pennsylvania, South Dakota
Racetrack casinos Delaware, Florida, Iowa, Louisiana, Maine, New Mexico, New York, Oklahoma, Pennsylvania, Rhode Island, West Virginia
Electronic gaming devices (e.g., video lotteries, bingo or poker games) at casinos and/or bars, restaurants or other licensed establishments 37 states
Tribal gaming (casinos, bingo, pulltabs, etc.) 28 states
Lotteries 41 states plus the District of Columbia
Parimutuel wagering 43 states
Charitable gaming 47 states plus the District of Columbia
Source: American Gaming Association, National Indian Gaming Association (April 2008 data)

At Nevada’s legal sports books, bets are placed on the NCAA tournament not only by filling out the popular brackets but also on the outcome of each game. You also can place “prop,” or proposition wagers, on such things as who will sink the first and last shots or foul out first. Essentially, if it happens (or could happen) in a game, the Nevada sports-book operation will take a bet on it. And because the tournament goes on for weeks, bettors have many more ways to drop some money on a game or games.

The tax man has a way to track legal athletic wagering. It’s a dicier tax-collection proposition, however, when it comes to bets placed at increasingly popular offshore sports-betting operations, dollars dropped into friendly office pools and illegal wagers handled by bookies. These bets, according to the American Gaming Association, represent more than 99 percent of all sports betting nationwide. The National Gambling Impact Study Commission estimates that translates to as much as $380 billion annually in illegal wagers.

For whom the tax bells toll

Legal betting operations — state lotteries, casinos and horse racing tracks — are regulated. One of the government agencies that has a say in these operations is the IRS. As soon as the bells go off when someone hits the slots jackpot, a casino representative is on hand to the get winner’s tax information.

In some cases, Uncle Sam even gets his cut (25 percent on most winnings) before you get your payout. That’s the case for winnings of more than $5,000 from any sweepstakes, wagering pool or lottery; withholding also is collected on proceeds that are 300 times or more the amount of the bet. Gambling winnings from bingo, keno and the slots are not generally subject to withholding, but you’re still required to provide your tax ID. If you refuse, the casino can assess backup withholding of your jackpot at a 28-percent rate.

Last year, the IRS also started getting reports from poker tournament sponsors when tournament winnings exceeded $5,000. The reporting requirement, aimed at poker tournament sponsors, including casinos, helps the IRS ensure that card-game winners are including their winnings on their annual tax returns.

Those poker tourney winnings, along with your jackpots from the casino or horse track or lottery dealer, will be recorded on Form W-2G showing how much you won and how much, if any, was withheld for federal taxes. And like all other income reporting forms, a copy will go to the IRS.

But there’s a distinction between what’s reportable and what’s taxable.

All gambling winnings — regardless of the amount — are taxable. But it’s ultimately the winner’s responsibility to let the IRS know how much was won, even if the casino doesn’t have to file a W-2G. This reliance on the gambler’s tax-law compliance is where the IRS frequently gets shortchanged.

How tempting is it to assume the IRS won’t miss a small jackpot? Apparently pretty darn appealing.

“On a trip to Vegas, I won $146 at a slot machine,” admits a chagrined economics professor at a church-financed university, “and I didn’t report it on my tax return.”

Making a bad day at the track pay off

The professor’s tax reporting inclination is one shared by many gaming winners, but not all.

IRS analysis of 2006 returns, the latest year for which data are complete, shows almost 1.9 million taxpayers reported almost $28 billion in gambling income. This includes winnings from casinos and horse tracks, lottery and raffle jackpots, as well as the fair market value of cars, houses and other noncash prizes.

As for how many taxpayers didn’t bare all about their betting at tax time, the IRS won’t even venture a guess. “We can’t tell you what we don’t know,” says an IRS spokesman.

But the IRS has a tax break for conscientious taxpayers who report their gambling income on line 21 of their Form 1040. They can subtract any gambling losses from winnings if they itemize. For many, that’s a good deal. That same 2006 data shows that more than 1 million gamblers that tax year made their good luck less taxing by claiming slightly more than $19 billion in bad bets.

Losses to reduce gambling winnings don’t have to be from the same game. If you go to the race track every weekend and drop $1,000 but then win $3,000 on the World Series, those losing horse betting slips can reduce the amount of baseball winnings on which you’ll owe tax.

There are a couple of ground rules to keep in mind here. First, you can’t claim more in losses than you won. And, as with any tax deduction, you need to keep records of your losses that will satisfy the IRS if you’re ever audited.

Good records are the best bet

Retired IRS agent Don Roberts recommends keeping track of gambling losses as you go through the year so you’re not scrambling to reconstruct them if you do hit it big.

Such reconstruction efforts not only are difficult, they aren’t likely to pass IRS scrutiny. Tax professionals recall a horse race fanatic who went to tax court with bags full of losing betting slips to support his large deduction against his winnings.

It didn’t work; almost every ticket was covered with footsteps of the other bettors who tossed the tickets when their horses didn’t win. He ended up paying the extra tax — and penalties.

“It’s not a tax myth, but it is an old story,” says Roberts, who saw similar actions when he worked for the tax office in Saratoga, N.Y.

“And if you don’t have a big win to offset,” he adds, “then the receipts can be your ticket to Gamblers Anonymous.”