You Won! Now Pay Up!

I won the grand prize in a local radio contest. Do I have to pay taxes on my loot?

Congratulations on your good fortune. We're sure you've already found a way to put that extra $2,500 to use.

But we hope you saved a piece for Uncle Sam, since this prize is indeed taxable. In fact, all winnings from gambling, raffles, and TV or radio game shows are taxable — as are your office Super Bowl and March Madness profits. All of these should be reported as "other income" on line 21 of your 1040 form.

"You got the prize, you got the tax," says CPA Jackie Perlman, senior tax research coordinator for H&R Block. "If you don't want to pay the tax, don't accept it."

Of course, who could say no to anything that's free — be it $2,500 or a tony new 2005 Pontiac G6? Oprah Winfrey gave away 276 of the latter last fall. But the new-car smell had hardly worn off before the lucky audience members realized they had to pay taxes on the $24,000 vehicles. Donna Levalley, a tax attorney and contributing editor to J. K. Lasser's Your Income Tax Guide 2005, estimates that the generous gifts may cost their new owners $7,000 or more in federal and state income taxes. "It's not bad — if you can afford it," she says. (For non-cash awards, the winners pay tax on the true market value, which is usually announced by the prize giver.)

To add insult to injury, if the prize is large enough to increase the winner's tax bill by more than $1,000 compared with the previous year, they may have to pay estimated taxes for the remainder of the year. (For the rules on estimated taxes, read our story or download IRS publication 505: Tax Withholding and Estimated Taxes.) The estimated tax rules and formulas are tricky, so folks who find themselves with a cash windfall might want to consult a tax professional right away.

In some cases, the prize giver will withhold taxes from the award in advance, at a flat rate that's currently 25%, says Levalley. At a casino, for example, this is required for winnings of $5,000 or more, though winnings from slot machines are usually excluded. If winnings are withheld, you will receive a form W-2G to use for reporting your winnings and withholding on your tax return. (Come April 15, you will be refunded the difference if the withholding was higher than your actual tax rate or owe more taxes if it was lower.) In those cases, you do not have to pay estimated taxes on the amount.

And what if the prize grantor generously decides to cover your tax payments? That money is also taxed, says Levalley. ABC's "Live With Regis and Kelly" show, for example, is giving away one Pontiac Montana SV6 sport van each day until February 28. They're also throwing in a cash award equal to the actual federal, state and local taxes the winner will owe. In this situation, the winner will report and owe tax on the total of the car's worth and the cash award, but only the taxes on the cash award will come out of their own pocket.

The good news is that you can offset the taxes on gambling or lottery winnings by deducting any losses you had during the year. Note, however, that there are strict limitations. To start with, you can deduct losses only up to the amount of your winnings, says Levalley. And then you must distinguish between gambling and lottery winnings and sweepstakes prizes: You can use gambling losses or lottery tickets only to offset gambling or lottery winnings, says Levalley. You can't take a deduction to offset a sweepstakes prize if you didn't pay anything to enter it.

Finally, if you decide to deduct losses, make sure you have sufficient documentation to prove them. "Don't think you're going to be cute and make up some number to put on Schedule A to offset your winnings," Perlman says. If you get audited — and a gambler's odds of an audit do go up, she says — make sure you have a detailed log of your casino winnings and losses, or your old lottery tickets and the sales receipts for them.