Everything You Need to Know About the Hottest New Way to Lose Money and How Uncle Sam Gets His Cut Either Way

Friends, gather ’round. Your favorite tax geek needs to talk to you about something that’s sweeping the nation faster than a Costco sample tray on a Saturday afternoon: prediction markets.

You know how your Uncle Vinny used to say, “I’d bet you a hundred bucks the Jets don’t make the playoffs”? Well, congratulations! Silicon Valley has taken Uncle Vinny’s barroom wager, wrapped it in fintech, slapped a CFTC registration on it, given it a $1 billion valuation, and now calls it a “financial instrument.” Madonna mia. 🤌

Prediction markets like Kalshi , Polymarket , and Myriad have absolutely exploded. Trading volume surged from $158 billion in 2024 to a staggering $635 billion in 2025. The mainstream financial media now reports prediction market odds alongside traditional polling data like they’re the same thing. CNBC is running how-to guides. The CFTC Chairman is writing op-eds defending their existence. And somewhere, Uncle Vinny is wondering why he didn’t patent his system.

But here’s the deal (and you knew this was coming) nobody seems to be talking about the tax implications. I’m a little obsessed with the tax complications raised by this newest innovation in “financial instruments”. The tax treatment of prediction markets is a beautiful, glorious, uncharted mess. It’s like the IRS looked at this entire $635 billion market and said, “We’ll get back to you.” Spoiler: they haven’t gotten back to anyone.

Let’s dive in.

What Are Prediction Markets? (Besides Gambling With a Business Degree)

Let me explain this in terms even your Uncle Vinny can understand. A prediction market is a platform where you buy and sell contracts tied to the outcome of real-world events. Will it snow in New York on April 1? Will the Fed raise rates? Will the Seahawks win the Super Bowl? Will the next Supreme Court vacancy happen before June?

If someone has set up a market for it, you can trade on it. Yes, it does sound the same as your Uncle Vinny’s barroom wager.

How the Mechanics Work

Every contract has two sides: YES and NO . Each share is priced between $0.01 and $0.99, and the price reflects the market’s collective wisdom about the probability of the event occurring. When the event resolves, the winning side pays out $1.00 per share . The losing side gets $0.00 . Zero. Nada. Niente.

Here’s a quick example:

• You think there’s a 70% chance the Fed raises rates in March, but the market is pricing YES shares at $0.55.
• You buy 1,000 YES shares at $0.55 each = $550 invested.
• The Fed raises rates. Your shares resolve at $1.00 each = $1,000 payout.
• Your profit: $450. Not bad for being smarter than the crowd.
• The Fed doesn’t raise rates? Your shares resolve at $0.00. You lose your $550. Arrivederci, money.

The beautiful wrinkle is that you don’t have to wait for the event to resolve. If the market moves in your favor — say those $0.55 shares jump to $0.80 after a hot inflation report, you can sell your position and pocket the difference. It’s like day trading, except instead of analyzing earnings reports, you’re analyzing whether Elon Musk will tweet something controversial before Thursday. (Spoiler: yes.)

Who Are the Major Players?

Platform

Settlement

Regulatory Status

Key Feature

Kalshi

U.S. Dollars (USD)

CFTC-regulated Designated Contract Market

Largest by trading volume; $1B+ valuation

Polymarket

Digital assets (on-chain)

Decentralized; recently re-entered U.S. market

Crypto-native; higher liquidity via AMM-style mechanics

Myriad

Digital assets (on-chain)

Decentralized

Automated Market Maker model; anyone can provide liquidity

The critical distinction here is that unlike a casino, you’re not betting against the house . The platforms facilitate peer-to-peer trading and collect a small transaction fee. It’s much closer to a stock exchange than a poker table, at least in theory. The CFTC agrees, and has been aggressively defending its exclusive jurisdiction over these markets against state regulators who’d rather classify them as gambling.

Whether or not YOU think it’s gambling? Well, that’s between you, your conscience, and your tax return.

How People Actually Make Money (Or Don’t)

There are essentially three strategies in prediction markets, ranging from “that’s clever” to “I need to lie down”:

1. The Conviction Play

You genuinely believe you know something the market doesn’t. Maybe you follow Fed policy obsessively, or you have deep industry knowledge about regulatory timelines. You buy underpriced YES or NO contracts and hold until resolution. This is the prediction market equivalent of value investing, and it works about as often.

Research from the University of Illinois found that Kalshi’s prices actually exhibit a “favorite-longshot bias” meaning contracts on likely outcomes are slightly overpriced and contracts on unlikely outcomes are slightly underpriced. In other words, the “smart money” advantage may be thinner than you think.

1. The Momentum Trade

You don’t care about the actual outcome. You buy contracts before a catalytic event (a debate, an earnings report, an FOMC meeting) and sell after the probability shifts. You’re trading the movement , not the resolution. This is essentially day trading with extra steps and more Twitter scrolling.

1. The Arbitrage Play

This is where it gets spicy. Because different platforms sometimes price the same event differently, sharp traders can buy YES on one platform and NO on another, locking in a risk-free profit if the combined cost is less than $1.00. For example: YES on Kalshi at $0.52 + NO on Polymarket at $0.45 = $0.97 total cost for a guaranteed $1.00 payout. That’s a 3% return. Do it a thousand times and… well, you get it.

The catch? Arbitrage opportunities disappear fast, you need capital on multiple platforms, and the transaction costs and settlement timing can eat your profit faster than my Aunt Rosa eats biscotti. But hey, it sounds impressive at dinner parties.

Now for the Fun Part: How Is This Taxed? (Spoiler: Nobody Really Knows)

I’ve seen a lot of ambiguity over the time I have been practicing. The NIMCRUT vs. CRAT debate. The economic substance doctrine. Whether a horse breeding operation is a “business” or a “hobby.” But the tax treatment of prediction markets? This might be the most unsettled area in all of tax law right now.

Here’s what we know: the IRS has issued zero guidance specifically addressing prediction market contracts. No revenue rulings. No notices. No “friendly reminders.” Nothing. Niente. It’s like they’re pretending this $635 billion market doesn’t exist. Meanwhile, taxpayers and practitioners are left to apply existing statutory frameworks to instruments Congress never imagined which is a bit like using a 1986 road map to navigate a Tesla on autopilot.

The Two Competing Frameworks

Tax professionals, the smart, reasonable, credentialed ones, genuinely disagree on how to characterize prediction market income. There are two primary schools of thought:

Framework 1: Capital Asset / Property Treatment

Under this view, a prediction market contract is a transferable contractual right you acquired for consideration and disposed of for value. You bought something, it changed in value, you sold it (or it settled). That’s a §1001 realization event, and the gain or loss is analyzed under §1221 as a capital gain or loss.

What this means for you:

• Short-term capital gains (held less than a year) taxed at ordinary rates
• Long-term capital gains (rare, but possible) taxed at preferential rates
• Losses can offset other capital gains — including crypto, stock, and other investment gains
• Net capital losses can offset up to $3,000 of ordinary income per year

Framework 2: Ordinary Income Treatment

Under this view, these contracts are non-equity, cash-settled instruments that don’t fit neatly into capital asset categories. Income and loss are treated as ordinary, reported outside Schedule D. This is the “conservative” approach.

What this means for you:

• All gains taxed at ordinary income rates (potentially higher)
• Losses are still generally netted against gains (this is NOT gambling treatment)
• Simpler reporting mechanics

Important distinction: Ordinary income treatment is NOT the same as gambling treatment . Under gambling rules, losses can only offset winnings. They can’t offset your salary, your business income, or anything else. Under the ordinary income framework for prediction markets, losses and gains are still netted. This is a crucial difference that many people (and some lazy preparers) get wrong.

The §1256 Question: The Holy Grail (That Might Be a Mirage)

Now here’s where things get really interesting for our high-volume friends. Section 1256 of the IRC provides a special tax regime for certain regulated futures contracts and exchange-traded options. The magic? The 60/40 rule : 60% of net gain is treated as long-term capital gain and 40% as short-term, regardless of how long you held the position .

At maximum rates, this blends to roughly a 26.8% effective rate instead of 37% for ordinary income. For someone making serious money on prediction markets, that spread is… well, it’s a lot of espresso money.

Kalshi’s status as a CFTC-regulated Designated Contract Market has led many participants to assume §1256 automatically applies. After all, it trades on a regulated exchange, the contracts are standardized, they’re marked to market. It looks like a regulated futures contract, right?

Not so fast. Here’s the reality check:

• 1256 is a narrowly constructed statutory regime that applies ONLY to specifically enumerated instruments
• Event-based prediction contracts are not expressly included in those categories
• CFTC regulation may satisfy the “qualified board or exchange” requirement, but regulatory status alone does not determine tax treatment
• The IRC controls the analysis, not the Commodity Exchange Act
• There is no IRS guidance confirming whether prediction markets qualify

As one analysis put it perfectly: “CFTC regulation is necessary but not sufficient”. Taking a §1256 position isn’t frivolous but it’s not a slam dunk either. It’s more like a half-court shot that might go in, and if it doesn’t, you’d better have good documentation for why you took it.

The OBBBA Reporting Wrinkle

The One Big Beautiful Bill Act actually changed the game on reporting thresholds. Starting in 2026, the threshold for Forms W-2G (gambling winnings) was raised significantly to $2,000 , with withholding at $5,000, plus a requirement that winnings exceed 300 times the amount of the wager . If prediction markets are treated under gambling rules (which, again, they probably shouldn’t be), this higher threshold means fewer information returns.

But here’s the thing, the 1099-K reporting threshold for payment platforms was raised to $2,000 starting with payments made in 2026. So the information reporting landscape is shifting regardless. The IRS may not have issued guidance, but don’t think for a second they aren’t watching the money flow.

The Crypto Wrinkle: Polymarket and On-Chain Settlement

If you thought this was complicated with USD-settled platforms like Kalshi, let me introduce you to the Inception-level dream-within-a-dream that is on-chain prediction markets.

Polymarket — which just re-entered the U.S. market — settles contracts in digital assets, not dollars. This means that on TOP of the prediction market tax analysis, you now have a stacked basis chain problem:

1. Layer 1: Basis in the prediction market contract itself
2. Layer 2: Fair market value of the digital asset received at settlement
3. Layer 3: Subsequent basis and disposition of that digital asset when you convert to USD

Each layer must be tracked, timestamped, valued in USD at the exact moment of settlement, and reconciled across wallets. Gas fees may affect basis. Smart contract mechanics may affect timing. And the 1099-DA reporting infrastructure the IRS is building for digital assets is expanding, not contracting .

It’s like doing your taxes while juggling flaming chainsaws on a unicycle. On a boat. In a storm.

Practical Tax Advice: What You Should Actually Do

Alright, enough theory. Here’s the action plan because that’s what we do:

1. Accept That This Is Taxable (No, Really)

The absence of a 1099 does not mean the absence of a tax obligation. The IRS doesn’t need a platform to send them a form to come knocking. Payment rails, bank deposits, and blockchain records all create data trails. Report your activity. Period.

1. Pick a Framework and Be Consistent

Whether you treat prediction market income as capital gains, ordinary income, or (if you’re feeling adventurous) §1256, pick one position and stick with it . The worst thing you can do is treat winners as capital gains and losers as ordinary losses depending on which is more advantageous. The IRS has a word for that: fraud. OK, they might start with “inconsistent” but you get the idea.

1. Track Every. Single. Transaction.

Do NOT rely on platform dashboards. They are designed for user experience, not tax compliance. Export your full transaction logs. Track acquisition date, cost basis, disposition date, and proceeds for every contract. Yes, every one. If you made 500 trades, you need 500 line items. I’m sorry. I don’t make the rules. (Actually, nobody made these rules. That’s the whole problem.)

1. Don’t Assume §1256 Without Analysis

If you’re going to take the 60/40 position, make sure you (or your tax advisor) can articulate why your specific contracts qualify under the statutory definitions. “Because Kalshi is CFTC-regulated” is not sufficient. You need a defensible position grounded in the Code, not just vibes and a Reddit thread.

1. Keep Prediction Market Activity Separate from Gambling

If you also do traditional sports betting, do NOT commingle those activities with prediction markets on your return. The tax treatment is potentially very different. Gambling losses can only offset gambling winnings, while prediction market losses (under property or ordinary frameworks) have broader utility.

1. Watch for Straddle Issues

If you’re holding offsetting YES and NO positions, or rolling positions across related events, you may be triggering federal straddle rules that defer loss recognition. This is an advanced issue, but if you’re doing multi-leg strategies, you need to be aware of it.

1. State Taxes Are a Separate Nightmare

Oh, you thought we were done? State conformity with federal capital loss limitations, netting rules, and income classifications varies wildly . Some states don’t have capital gains preferences. Some have their own gambling frameworks. And given the conformity chaos we discussed in our last blog post, well, let’s just say prediction markets and multi-state taxation is a match made in Purgatorio.

1. Get Help If You’re Active

If your prediction market activity involves multiple contracts, recurring trading, or meaningful dollar amounts and especially if you’re on Polymarket or another crypto-settled platform this is not DIY territory . The reconstruction burden alone can be substantial, and the IRS matching infrastructure is only getting more sophisticated.

The Bottom Line: It’s Exciting, It’s Growing, and the IRS Is Late to the Party

Prediction markets are one of the most fascinating financial innovations in a generation. They aggregate information, they create genuine price discovery, and they give regular people a way to put money where their mouth is on everything from monetary policy to weather patterns. The CFTC calls them tools for “hedging event-driven risks” and “providing the public with information about the outcome of future events”. Uncle Vinny calls them “the thing I’ve been doing at the bar for 30 years.”

They’re both right.

But until the IRS decides to actually weigh in, and I wouldn’t hold my breath, because they’re still busy issuing guidance on the OBBBA, you’re operating in a tax gray zone the size of Montana. The smart move is to treat it seriously, document everything, pick a defensible position, and work with someone who understands both the financial instruments and the tax code.

Because here’s what I know: the IRS always gets around to it eventually. And when they do, you want to be the person with clean records and a consistent position, not the person explaining to an examiner why you reported your Polymarket profits on a napkin.

Whether you’re dabbling in prediction markets, diving in headfirst, or just trying to figure out what your kid is doing on their phone, we can help you navigate the tax side of this brave new world of prediction markets. Because honestly? The only thing you should be betting on with certainty is that Uncle Sam wants his cut. Reach out to us at [email protected] and we’ll make sure your prediction market tax position is one worth wagering on.

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