How Life Settlements Are Taxed: Basis, Ordinary Income, and Capital Gains

If you are evaluating the economics of your life insurance portfolio, exploring your policy’s life settlement value can be a strategic move. Policies that were once purchased for estate planning, business succession, key person, buy-sell, or income protection may no longer serve their original purpose. In those cases, the question becomes: Is it better to surrender the policy for its cash value, or sell the policy in the life settlement market?

Understanding the tax implications of each option is critical for maximizing the financial outcome. Fortunately, federal tax treatment of life settlements has become much clearer and more favorable in recent years, creating a more straightforward framework for policyowners and advisors. Below is a guide to how life settlements are taxed today, and why selling a policy can sometimes produce a more favorable economic result than surrendering it.

A Brief Historical Perspective

The Foundation: Life Insurance as Transferable Property

The life settlement industry traces its roots to the landmark 1911 U.S. Supreme Court decision in Grigsby v. Russell, which established that a life insurance policy is personal property that can be transferred or sold. This ruling laid the legal foundation for today’s life settlement marketplace.

Early Complexity in Tax Treatment

As life settlements began gaining traction in the early 2000s, the IRS struggled to define the proper tax treatment. Revenue Ruling 2009-13 introduced a complicated framework that required policyowners to reduce their cost basis by the cumulative cost of insurance (COI) charges when calculating gain. This approach often produced unexpected taxable income, even when the policyowner had paid substantial premiums.

The rule also created a disconnect between:

• Policy surrender taxation

• Life settlement taxation

The result was confusion among advisors and taxpayers alike.

The Turning Point: Favorable Tax Reforms

Two major developments simplified the rules and improved the tax outcome for policyowners.

Tax Cuts and Jobs Act (2017)

The Tax Cuts and Jobs Act (TCJA) eliminated the requirement to subtract cumulative cost of insurance charges when determining a policyowner’s tax basis. In practical terms, this means:

Cost Basis = Total Premiums Paid

This change significantly increased the tax basis for most policyowners and reduced the amount of taxable gain when a policy is sold.

Revenue Ruling 2020-05

In January 2020, the IRS issued Revenue Ruling 2020-05, which aligned the tax treatment of policy sales and policy surrenders. This ruling removed many of the inconsistencies between the two transactions and confirmed a clearer framework for calculating taxable income.

How Life Settlements Are Taxed

Today, taxation of a life settlement follows a three-tier structure.

Tier 1: Return of Basis (Not Taxable)

Your cost basis equals the total premiums paid into the policy. Any settlement proceeds up to that amount are considered a return of capital and are not taxable.

Tier 2: Ordinary Income

If the cash surrender value exceeds the cost basis, the difference is taxed as ordinary income. This portion represents the policy’s internal buildup that would have been taxed as ordinary income if the policy were surrendered.

Tier 3: Long-Term Capital Gain

Any additional amount received above the cash surrender value is taxed as long-term capital gain. This portion reflects the additional value created by selling the policy in the secondary market, often driven by life expectancy projections and the future death benefit.

---

Policy Surrender vs. Life Settlement:

What Happens If the Policy Is Sold at a Loss?

An important, but often overlooked, difference arises when a policyowner receives less than their total premiums paid into the policy. This scenario frequently occurs when:

• A policy was funded heavily in early years

• A policy was thinly funded year-to-year with very low policy cash value

• Interest rate lowered or earnings were less than anticipated

• Insurance costs increased

In these situations, policyowners often assume surrendering the policy is their only option.

The tax treatment differs significantly between surrendering and selling a policy for a loss.

Scenario 1: Surrendering a Life Insurance Policy at a Loss

When a policy is surrendered to the insurance company, the tax code generally does not allow the loss to be deducted. Example:

Premiums Paid: $500,000

Cash Surrender Value: $350,000

Economic Loss: ($150,000)

Unfortunately, because the policy was a personal asset, the $150,000 loss is typically considered a non-deductible personal loss under current tax rules. Result:

• You recover the $350,000 tax-free (return of basis)

• The $150,000 economic loss cannot be used to offset income or gains

In other words, the loss disappears for tax purposes.

Scenario 2: Selling the Policy in a Life Settlement at a Loss

A life settlement sale may produce a different tax outcome. If the policy is sold for less than the cost basis, the transaction may generate a capital loss, which can potentially be used to offset other capital gains. Example:

Premiums Paid: $500,000

Life Settlement Offer: $350,000

Economic Loss: ($150,000)

Because the transaction involves the sale of a capital asset, the $150,000 loss may be treated as a capital loss. Capital losses can potentially:

• Offset capital gains from investments

• Offset up to $3,000 of ordinary income annually

• Carry forward to future tax years

While tax treatment ultimately depends on individual circumstances and tax professional advice, this difference highlights why evaluating a life settlement offer before surrendering a policy is often worthwhile, even at a loss.

Why Life Settlements Can Produce Economic Value

In many cases, a life settlement can generate significantly more value than the policy’s surrender value. This is because life settlement investors evaluate the policy differently than insurance companies. Insurance carriers price surrender values based on policy reserves, while life settlement buyers evaluate:

• Life expectancy

• Future premium obligations

• Death benefit size

• Investment return expectations

As a result, the life settlement market sometimes pays significantly higher than the surrender value for life insurance policies.

The Strategic Takeaway

When a life insurance policy is no longer needed, policyowners generally have three options:

1. Continue the policy

2. Surrender the policy for its cash value

3. Sell the policy in the life settlement market

Because the tax treatment and economic outcomes can differ meaningfully, evaluating all three options is a prudent step. Even if a policy ultimately is surrendered, understanding the potential life settlement value provides an important benchmark for making an informed economic decision. Let's connect if you would like to evaluate a life settlement versus a policy surrender for your life insurance policy.

This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Information obtained from third-party sources are believed to be reliable but not guaranteed.

The tax and legal references attached herein are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.