Last Updated on May 17, 2026 by Patrick Camuso, CPA
Quick answer (read this first):
What this article addresses: What happens when a prediction market tax position filed in a prior year gets challenged or recharacterized, including Section 1256 treatment. This article is for participants who already filed and are now uncertain about their position and want to know what happens if the IRS recharacterizes your prediction market gains and losses?.
What is unsettled: The IRS has issued no guidance on prediction market contract characterization. That cuts both ways. The positions that were filed may remain defensible, but the absence of guidance also means no safe harbor exists for any characterization.
Why Recharacterization Risk Is Real Now
Most prediction market participants who filed 2024 and 2025 returns did so without IRS guidance, without court authority, and without a settled analytical framework. That was unavoidable. The positions that were filed, whether Section 1256, capital asset treatment, or ordinary income, were chosen based on reasonable interpretations of existing law applied to a novel instrument class.
The risk that those positions get challenged has not materialized yet at scale. The IRS has not announced any examination initiative targeting prediction market returns, and the volume of activity on regulated platforms like Kalshi only became significant in 2024. For most participants, the near-term examination risk is low.
But the law does not stop applying because the IRS is not yet examining a category of returns. A participant who filed an aggressive position sits with that position on the return for the full three-year statute of limitations period, or six years if a substantial omission of income is involved. If IRS guidance eventually clarifies the characterization in a way that disfavors the filed position, examination risk increases substantially. That is the exposure this article addresses.
For a detailed breakdown of how prediction market income should be characterized and what framework applies to each contract type, see our prediction market tax guide.
The Most Common Aggressive Positions Filed
Section 1256 Treatment
Section 1256 treatment produces a 60 percent long-term / 40 percent short-term capital gain split regardless of actual holding period, and allows loss carrybacks. At high income levels, the effective rate on a net gain position is materially lower than ordinary income treatment.
The problem is that Section 1256 requires the contracts to be regulated futures contracts, foreign currency contracts, non-equity options, or dealer equity options. Prediction market event contracts do not satisfy the regulated futures contract definition. Regulated futures contracts require daily mark-to-market margining and Kalshi binary contracts do not have that structure. The non-equity option path is more analytically viable but unresolved. The IRS has not addressed it. Published practitioner analysis identifies it as a potential path but does not endorse it as a settled position, and the IRS has a documented pattern of construing novel instrument classifications narrowly in the Section 1256 context.
A participant who filed Section 1256 treatment on Kalshi contracts filed an aggressive position with no direct authority and meaningful blocking arguments. If the IRS recharacterizes, the gains convert from the 60/40 split to either short-term capital gains or ordinary income, depending on the underlying contract characterization.
Capital Asset Treatment on Sports Contracts
Sports event contracts carry significant wagering risk under Section 165(d). A participant who filed capital asset treatment, with or without a Form 8275 disclosure, took a position that the CFTC-regulated exchange structure takes the contracts outside the wagering framework. That argument is analytically available but contested.
If the IRS recharacterizes sports contract gains from capital to ordinary income or gambling income, the consequences depend on the participant’s net position. In a net gain year, the rate impact may be significant. In a net loss year, the impact depends on the tax year. For 2024 and 2025 returns, the pre-OBBBA rule governs and losses are fully deductible against winnings with no percentage cap. A breakeven year recharacterized to wagering on a 2024 or 2025 return owes no additional tax on the loss side. For 2026 and later returns, the OBBBA 90 percent loss cap creates phantom income on a breakeven year, which can produce significant unexpected tax liability.
Capital or Ordinary Income Without Form 8275 Disclosure
A participant who reported prediction market gains as capital gains without filing a Form 8275 disclosure took a position that is factually defensible in some contexts, particularly for macro/financial contracts, but undisclosed. Without disclosure, the accuracy-related penalty protection that Form 8275 provides is not available if the position is later challenged and the underlying authority does not meet the substantial authority standard.
What IRS Recharacterization May Produce
Recharacterization changes the loss treatment framework more than the rate. The rate impact gets the attention, but for many participants the loss deduction question is what creates the actual tax bill. The three scenarios below are ordered by severity of the loss impact.
Capital asset treatment recharacterized to ordinary income with extinguishment doctrine applied.
If the IRS takes the position that prediction market event contracts lack underlying property for Section 1234A purposes, contract resolution is extinguishment rather than a sale or exchange. Gains are ordinary income. Losses are completely nondeductible. A participant with a mixed gain/loss year who assumed full loss deductibility under capital treatment could owe tax on their gross winning contracts with no offset from losing contracts at all. A participant who broke even economically could owe significant tax.
Capital asset treatment recharacterized to wagering.
The consequences differ by tax year, and this distinction matters. For 2024 and 2025 returns, the pre-OBBBA rule governs, gambling losses are deductible against gambling winnings without any percentage cap. A participant who broke even economically on a 2024 or 2025 return that is recharacterized to wagering treatment owes no additional tax on the loss side. The losses offset the winnings dollar for dollar. The impact in those years is primarily a rate and reporting change, not a loss disallowance.
For 2026 and later returns, the OBBBA 90 percent loss cap applies. A participant who breaks even economically on a 2026 return that is filed under capital treatment but should be wagering treatment would owe tax on 10 percent of gross wagering winnings if recharacterized. The phantom income problem is a 2026-forward issue, not a retroactive one. Participants evaluating prior year exposure should not apply the 90 percent cap analysis to 2024 or 2025 returns.
Section 1256 recharacterized to ordinary income or short-term capital gains.
The 60/40 split converts. Long-term capital gain that was taxed at preferred rates becomes ordinary income taxed at marginal rates. The rate difference in a high-income year can be 15 to 20 percentage points on the long-term portion. Section 1256 loss carrybacks that were applied to prior years become unavailable, which may require amendments to the carryback years and create additional tax liability in those years.
Penalty Exposure Under Section 6662
An accuracy-related penalty of 20 percent applies to the underpayment of tax attributable to any substantial understatement of income tax. A substantial understatement exists when the understatement exceeds the greater of 10 percent of the correct tax or $5,000. For participants with material prediction market activity, the recharacterization of a Section 1256 position or capital asset position will frequently produce an understatement that meets this threshold.
The penalty is not automatic. It does not apply where there was reasonable cause and the taxpayer acted in good faith, or where the position had substantial authority. The reasonable cause and good faith determination is facts-specific and depends on the adequacy of the research conducted and the disclosure made.
Substantial authority exists where the weight of the authorities supporting the position is substantial in relation to the weight of the authorities in opposition. Given the absence of IRS guidance on prediction market contract characterization, the question of whether any particular position meets the substantial authority standard is genuinely uncertain. A practitioner arguing that Section 1256 treatment has substantial authority faces the problem that no authority directly supports it and several authorities cut against it.
Reasonable basis is a lower threshold, approximately a 20 percent or greater likelihood of being sustained. Reasonable basis protects against the penalty only where the position is adequately disclosed on Form 8275. Without disclosure, reasonable basis provides no penalty protection.
Form 8275 is the mechanism for adequate disclosure. A return position that meets only the reasonable basis standard requires Form 8275 disclosure to avoid the accuracy-related penalty. A return position that meets the substantial authority standard does not require disclosure but benefits from it. The form requires identifying the item, the relevant Code section, and the legal basis for the position.
A participant who filed an aggressive prediction market position without a Form 8275 disclosure has no penalty protection below the substantial authority threshold. A participant who filed with a Form 8275 that accurately disclosed the position has penalty protection down to the reasonable basis threshold.
What to Do If You Filed an Aggressive Position
The decision to amend, disclose retroactively, or hold the filed position depends on four factors including the size of the potential underpayment, the defensibility of the original position, the statute of limitations, and the current examination risk.
Assess the Position Honestly
The first step is an honest assessment of where the filed position actually sits on the defensibility spectrum. The relevant question is not whether the position was reasonable to take at the time. It may well have been. The question is what authority exists to support it now, given the current state of the law.
For Section 1256 positions on Kalshi contracts, the non-equity option path is analytically available but not established. A practitioner evaluating this position today would likely conclude it does not meet the substantial authority standard and may not meet the reasonable basis standard without additional analytical support. For capital asset positions on sports contracts, whether it meets the substantial authority standard depends on the weight of the wagering-specific arguments given the contract type. For capital asset or ordinary income positions with adequate Form 8275 disclosure, the position is generally protected against accuracy-related penalties down to the reasonable basis threshold. The risk is the underlying tax, not the penalty.
The Amended Return Decision
Amending a prior year return is not always the right answer, even where the filed position is now viewed as aggressive.
The potential underpayment is material or the position does not meet the reasonable basis standard even with disclosure. Where the filed position is genuinely indefensible, not just aggressive. Holding it creates ongoing exposure that does not improve with time. Form 8275 was not filed and the position is below the substantial authority threshold. Without disclosure, penalty exposure accrues from the original filing date. Amending to add the disclosure, or filing a standalone Form 8275 disclosure, may reduce that exposure.
An amended return is more likely to be reviewed than the original. Where examination risk is low and the statute of limitations is running, amending may create more risk than it resolves. IRS guidance on prediction market contract characterization is expected. Depending on what that guidance says, the filed position may be vindicated without any action by the taxpayer. Amending before that guidance arrives may be premature.
The position has a reasonable basis and was disclosed. Where Form 8275 was filed and the position meets the reasonable basis threshold, penalty protection exists and the risk is limited to the tax liability itself if the position is challenged. That risk is the same whether you amend now or later.
Consider a Formal Opinion Memo
For participants with material exposure, generally $100,000 or more in potential tax at issue, a formal tax opinion memo does several things. It documents the analytical basis for the filed position, strengthens the reasonable cause and good faith defense under Section 6664, establishes a contemporaneous record of the analysis, and gives the taxpayer an honest assessment of the risk before the IRS ever contacts them. A practitioner who cannot produce documented reasoning for a position has a weaker defense than one who can.
Statute of Limitations Considerations
The general statute of limitations for assessment is three years from the later of the return due date or the actual filing date. For a 2024 return filed April 15, 2025, the limitations period runs through April 15, 2028.
Two exceptions extend the period. First, if the return omits more than 25 percent of gross income, the limitations period extends to six years under Section 6501(e). This provision applies to items of income completely left off the return, not to income that was reported with the wrong character. A participant who reported the full dollar amount of prediction market gains as capital gains but should have reported them as ordinary income has not omitted income in the Section 6501(e) sense. The six-year period is unlikely to apply to a pure character recharacterization of income that was fully reported. It could apply where the recharacterization also produces income that was never reported at all, for example, where a character change eliminates deductions that would otherwise have created taxable income.
Second, the limitations period does not run where there is fraud with intent to evade tax. Civil fraud carries a 75 percent penalty and no limitations period. Aggressive characterization positions taken in good faith, even incorrectly, are not fraud. The fraud exception applies to deliberate concealment, not to good faith positions on unsettled law.
The limitations period is the taxpayer’s friend only where the IRS does not act within it. Where the IRS does examine and proposes adjustments within the limitations period, the fact that the period was running provides no protection against the proposed adjustments or the associated penalties.
For the framework that governs which characterization should apply to your specific prediction market contracts, see our prediction market tax guide.
For an analysis of whether prediction market profits are gambling income and how that determination is made, see Are Prediction Market Profits Gambling Income?
For the loss deduction framework and how characterization affects what losses can be deducted, see our prediction market loss deductions analysis.
For Section 1256 treatment and the arguments for and against its application to prediction market contracts, see our Section 1256 prediction market tax analysis.
For professional assistance reviewing a prior year filing position or evaluating whether an amended return is appropriate, our prediction market tax reporting services are available.
Frequently Asked Questions
I filed Section 1256 treatment on my Kalshi gains. What is my risk?
Section 1256 is the most aggressive commonly filed position for prediction market contracts. It has no direct statutory authority for Kalshi binary contracts. Regulated futures contract status requires daily mark-to-market margining that Kalshi contracts do not have. If the IRS recharacterizes, gains convert from the 60/40 split to short-term capital gains or ordinary income. Penalty exposure depends on whether a Form 8275 was filed and whether the position met the reasonable basis threshold. If you did not file a Form 8275 and the position does not meet substantial authority, the 20 percent accuracy-related penalty applies to the resulting underpayment. A professional evaluation of the position and the amended return decision is warranted for any material exposure.
What is the statute of limitations for IRS examination of my prediction market returns?
Three years from the later of the return due date or filing date in the general case. Six years if the return omits more than 25 percent of gross income under Section 6501(e), but this applies to items completely left off the return, not to income reported with the wrong character. A pure character recharacterization of income that was fully reported is unlikely to trigger the six-year period. There is no limitations period for fraud, but aggressive characterization positions taken in good faith do not constitute fraud.
If the IRS audits my return, can my position still be sustained?
Possibly. The absence of IRS guidance on prediction market contract characterization means the IRS cannot point to a published ruling or regulation directly contradicting your position. An examination of an aggressive prediction market return requires the IRS to develop its own position from first principles, which creates room for negotiation and advocacy. Whether a position can be sustained under examination depends on the strength of the underlying legal analysis, the quality of the documentation, and the specific facts of the participant’s activity. A practitioner who developed the original analytical framework is better positioned to defend it under examination than one engaging with the issue for the first time.
Should I wait for IRS guidance before deciding whether to amend?
For positions that have a documented reasonable basis and were disclosed on Form 8275, waiting is generally defensible. Guidance may vindicate the position. For positions that were not disclosed and do not clearly meet the reasonable basis threshold, waiting allows penalty exposure to accrue and the documented good faith record to remain thin. The statute of limitations runs regardless of whether guidance is issued. A practitioner review of the specific position is the right first step before making the amend-or-wait decision.
The analysis in this article is unsettled law applied to prior year filings in an area where no IRS guidance exists. No position in this article constitutes legal or tax advice. The appropriate course of action for any specific taxpayer depends on the facts of their return, the characterization position filed, the presence or absence of Form 8275 disclosure, and the size of the potential exposure. Professional analysis is required before any amended return decision is made.
For a full analytical framework covering prediction market tax characterization across all platforms and contract types, see our Prediction Market Tax Guide. For professional assistance reviewing a prior year filing position, our prediction market tax reporting services are available.
