June 28 , 2009 - I am considering a move into an assisted living facility and have been told that I might be able to sell my life insurance policy to cover the costs. How would that transaction affect my taxes?

Until recently, an individual who no longer needed a life insurance policy had few options. In general, he could surrender the policy to the issuing insurance company for its cash surrender value or he could stop paying the premiums and let the policy lapse. For a term insurance or other policy without cash surrender value, the only choice was to let the policy lapse. Now, for some individuals, there is a secondary insurance market in which they may be able to sell a policy for more than its cash surrender value or even sell a policy without cash surrender value, such as a term policy. These transactions are called life settlements. Some reports say that the average payout is 24% of the face amount of the policy but they can vary widely.

The IRS recently lifted some of the uncertainty surrounding life settlements by issuing a ruling explaining the tax consequences of life settlements. We will examine the tax treatment of surrenders of policies, which IRS also explained in the recent guidance.

With a life settlement, the insured is not terminally ill but typically has an impaired mortality. The life settlement industry evolved from the viatical settlement industry, which grew in popularity in the eighties with the advent of the AIDS virus. A viatical settlement is like a life settlement except that the insured is terminally or chronically ill.

The typical seller is age 65 or older with an impaired mortality and a life expectancy of between 2 and 12 years. The policy usually has a death benefit exceeding $250,000.

Reasons for considering a life settlement include:
• funds are needed to pay medical or long-term care expenses;
• insured can no longer afford the premiums;
• the primary beneficiary has died and the policy is no longer needed;
• the insured got divorced;
• business circumstances have changed and the coverage is no longer needed to fund a buy-sell agreement; and
• expected death tax costs have been reduced or eliminated and the coverage is no longer needed to pay death taxes.

The IRS has recently issued a Revenue Ruling explaining the tax treatment of policyholder surrenders and sales of life insurance contracts with and without cash value. The examples are as follows:

Ex. 1: On Jan 1, Year 1, A entered into a "life insurance contract: with cash value. On June 15 of Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of "cost-of-insurance" charges collected by the issuer. Through that date, A had paid total premiums of $64,000. Based on these facts, the IRS concluded that A has ordinary income of $14,000.

Ex. 2: The facts are the same as Ex. 1, except that on June 15 of Year 8, A sold the life insurance contract for $80,000 to an unrelated entity. Here, the IRS says A has a gain of $26,000 because the $10,000 of insurance protection reduces his basis for the premiums paid from $64,000 to $54,000. Of this $26,000, the IRS says that $14,000 is ordinary income and $12,000 is capital gain.

Ex. 3: The facts are the same as Ex. 1, except that the contract was a level premium fifteen-year term life insurance contract without cash surrender value. The monthly premium for the contract was $500. Through June 15 of Year 8, A paid premiums totaling $45,000. On June 15 of Year 8, A sold the contract for $20,000 to an unrelated entity. In this case, the amount realized from the sale of the term life insurance contract is the sum of money received from the sale, or $20,000. IRS says that A's adjusted basis is equal to the total premiums paid, less charges for the provision of insurance before the sale. The cost of the insurance protection provided to A during the 89.5 month period that A held the contract was $500 times 89.5 months, or $44,750. Hence A's basis in the contract was $250. Accordingly, A must recognize a long-term capital gain of $19,750 on the sale.

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