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Rewards cards such as Capital One's (NYSE: COF  ) Venture Card have their advantages. Sign up and you'll enjoy up-front bonuses and generous mileage payouts to spend on free travel. There's just one problem: "free" might not be free much longer.

Last week, L.A. Times columnist David Lazarus reported that Citigroup (NYSE: C  ) is sending tax statements to customers who received miles for signing up for a checking or savings account. Each mile is worth $0.025 in taxable income, Citi says. But they're wrong.

Why miles shouldn't be taxable
Before I get into why, let's talk about what's actually happening. Citi is sending statements to the Internal Revenue Service that show income, just as all banks send the IRS 1099 statements reporting interest income during the year. Brokerages send in similar forms reporting dividend income.

A copy of every year-end tax statement you have is sent to the feds. Fail to report the numbers within, and your chances of audit rise. Thus, in kicking off statements, Citi has put customers who were expecting free miles to be, well, free in a compromising position. Report the (ahem) "income" or risk an unwanted visit from Uncle Sam.

For its part, Citi told Lazarus that any prize or award that exceeds $600 must be reported to the IRS as taxable income per the 2012 instructions for IRS F orm 1099-MISC. The feds wouldn't clarify for him whether Citi was right or wrong in its interpretation.

The math of mileage
I've never been and won't ever be a tax agent, so I can't speak to the issue of taxability, but I do know that Citi's math is Washingtonian in its fuzziness. No airline program gets within spitting distance of offering $0.025 a mile worth of value to its members.

 Travel hacking site Nerd Wallet did the math and found that Continental's OnePass offered the most at $0.0101 a mile of value. But that was before the merger that created United Continental (NYSE: UAL  ) . We're only now seeing the effects of a combined program, but it's possible that the carrier's new Mileage Plus will offer not much more than the $0.0083 a mile in value it has historically.

Or consider the Venture Card. Capital One's terms and conditions say the company will reimburse $100 of airfare for every 10,000 miles spent, or $0.01 a mile. American Express (NYSE: AXP  ) allows its Membership Rewards customers to exchange 15,000 points for a $150 gift card, also $0.01 per point.

Most consider roughly $0.01 a mile the industry standard when valuing frequent flier miles. In Citi's case, opening an account qualified some for up to 23,500 American AAdvantage miles.

Nerd Wallet estimates the per-mile value of bankrupt American's program at $0.0076. But even if you call it the industry standard of $0.01, Citi isn't just sticking customers with a tax bill they didn't expect -- the bank is also grossly overstating mileage income, and therefore the resulting tax liability.

The other math of mileage
Even so, it's hard to blame Citi for overstating the value of miles. Banks make so much from offering them. Again, consider the Venture Card. Capital One dishes out two miles for every $1 spent. With interchange fee income, interest charges, and other fees that result from that extra spending, paying what amounts to $0.02 per dollar is a bargain. This, Fool, is a big part of why Capital One's U.S. credit card business enjoyed 46.5% pre-tax margins last year.

Citi doesn't do quite as well with a 31.5% pre-tax margin in its consumer banking segment, while American Express trails the pack at 28.7%. Yet I think it's fair to say maintaining those levels would be much harder without virtually free inducements such as miles to draw in potential customers.

United Continental and its peers enjoy a similar benefit. Mileage is a huge profit driver for how it draws in loyal flyers who tend to pay higher overall fares for business travel. Some even buy miles directly at what amount to outrageous rates. As of this writing, 2,000 miles that buy roughly $20 worth of redemption value will cost you $75.25. For carriers like banks, miles are a margin-maker.

What If the IRS acts?
Lazarus didn't get much when he asked the IRS to rule on Citi's decision, which leads me to believe that other issuers won't follow its lead. But if they do -- or if the feds decide that miles are income -- then it'll gut the value of rewards credit cards. Or at the very least, it might entice some travel hackers to gather up less than the $600 value limit across varying programs and then combine miles via trading portals such as Points.com. You can bet banks are hoping it doesn't come to that; sustained use increases the odds of collecting interest and boosting profits.

In the meantime, I'd strongly advise against signing up for any Citi-sponsored program that offers miles as an enticement. Also, be sure to read the terms and conditions before accepting any rewards card offer. What seems like a no-brainer could trap you with fees or payments you hadn't banked on.

And let's face it, if given the choice, we'd all rather earn than pay. This is as true for stocks as it is bank deals. I know because the Fool's free report profiling 11 high-yield dividend stocks remains one of our most popular. Click here to get it now -- it's 100% free but only available for a limited time.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's web home, portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Citigroup. Motley Fool newsletter services have recommended writing a covered strangle position on American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (1) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 31, 2012, at 4:43 PM, TMFMileHigh wrote:

    Fools,

    A Citi spokesperson who was kind enough to talk with me via phone a bit ago pointed out that only miles granted as a gift for opening a checking or savings account can be considered taxable.

    The same would holds true for any expensive gift, this person said, a point reinforced in this USA Today story that quotes H&R Block's Tax Institute:

    http://travel.usatoday.com/flights/story/2012-01-31/Citibank...

    By contrast, miles awarded for purchases are treated as rebates and therefore non-taxable under current law.

    I've yet to hear how or why miles were valued at up 2.5 cents each, but you can bet I'll write a follow-up if we're ever privy to those details.

    FWIW and Foolish best,

    Tim

    --

    Tim Beyers

    TMFMileHigh, Motley Fool Rule Breakers Analyst

    Web: http://timbeyers.me

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Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment, though you'll most often find him writing and talking about the business of comics. Find him online at timbeyers.me or send email to tbeyers@fool.com. For more insights, follow Tim on Google+ and Twitter.

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