Watch out for taxes if you sell your life insurance contract

The IRS has issued two new rulings addressing the sale and surrender of life insurance contracts from the point of view of policyholders and the investors. In this down economy, it can make good economic sense to sell an insurance policy that is no longer needed, or maybe can no longer be afforded.

The sale of an insurance policy is the sale of an asset; however, the gain could be either ordinary income (taxed like wages) or capital gain income (generally a lower tax rate). You will also need to take into account your investment in the policy (your tax basis).

Now, this discussion does not pertain to someone selling their insurance policy when they are either chronically ill or terminally ill. In those circumstances special exclusions generally will apply.

There are three situations under which you may be selling your policy.

  1. Surrender of the policy to the issuer for cash value.
  2. Sale of the policy with cash surrender value to an unrelated person.
  3. Sale of the policy with no cash surrender value to an unrelated person.

Here are the examples for each situation which demonstrate how the tax bite is determined.

Surrender of the policy. You give back to your insurance company your policy which has a $78,000 cash surrender value and a subtraction for $10,000 for "cost of insurance" charges for the period according to your statement. Up to the time you gave the policy back you paid $64,000 in total premiums. You would have to report $14,000 or ordinary income on your income tax return, or $78,000 minus your $64,000 investment.

Selling your cash value policy to an unrelated party. Assume the same as the first situation but you sell the policy for $80,000.  In this situation, you have income of $26,000 ($80,000 minus $64,000 premiums paid minus $10,000 cost of insurance). Of that $14,000 is taxed as ordinary income and $12,000 is capital gain income.

The main difference between the situations is that the amount realized in the first situation reflects teh reduction for the insurance charges. In the second situation because the insurance charges are a current expense and not an investment that adds to your basis, the insurance charges of $10,000 reduce your basis to $54,000. Now, here comes the fun. Why is the $14,000 tax as ordinary income? Thanks to something called the substitute for ordinary income doctrine. In other words, ordinary income that has been earned but not recognized by you and therefore cannot be converted into capital gain income.  Now how's that for being clear as mud. If you're really an insomniac the case to read that set this up is U.S. v. Midland-Ross Corp.

Selling your term life (no cash value) policy to an unrelated party. Assume you sell your level premium 15 term life policy to an unrelated part for which you paid $500 per month for the 90 months for total premiums of $45,000 paid for a total of $20,000.

As a term insurance policy the policy had no cash surrender value, so there was no inside buildup of value. As such, your total $20,000 will be considered capital gain income.

The Bottom Line

Be sure you carefully review your tax and financial situation with your CPA before making a decision. As you can see the tax consequence can be large and certainly complex.

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