Updated 1/29/2020, originally posted 10/26/18
In our last two blogs, we discussed when and how to sell a life insurance policy. In this blog entry, we want to talk about the taxation of a life insurance policy sale for the seller.
The death benefit of a life insurance held in trust is received free of both estate and income taxes, however, if a TOLI life insurance policy is sold, taxes may be due. The taxation of a life insurance policy is similar to, but not as simple as, a policy surrender for cash value, though the new tax law – the Tax Cuts and Jobs Act – did simplify the process.
Calculating the Taxation of a Life Settlement: A Three-Step Process
First, determine total gain by subtracting the cost basis of the policy, typically the total premium paid, from the amount received from the sale by the policy owner.
Second, determine that amount which will be taxed as ordinary income, which is the difference between the cash value in the policy and the cost basis. This is the same process used to calculate the taxable amount of a policy surrender. The cost basis in both transactions is received free of income tax – it is the return of premium paid. Before the new tax law, a policy seller would have to reduce the cost basis by the mortality charges paid in the policy, an arduous, sometimes impossible process, that increases the taxation of a policy sale.
Third, calculate that portion of the sale that will be taxed at capital gains rates by subtracting the amount taxed as ordinary income (second step) from the total gain (step one). The amount above the cash value is taxed as capital gains.
As can be seen from the chart, if a policy with a cost basis of $250,000, and a cash value of $400,000 was sold for $800,000, the total gain for the seller would be $550,000 ($800,000 sale price minus $250,000 cost basis received tax-free), $150,000 of that amount ($400,000 cash value minus $250,000 cost basis) would be taxed as ordinary income and $400,000 ($550,000 total gain minus $150,000 taxed as ordinary income) would be taxed at capital gains rates. Note that if there is no cash value in the policy, the total amount received above cost basis is taxed at capital gains rates.
Understanding life settlements will grow more important for the TOLI trustee over the coming years. For more information, review chapter 14 of the TOLI Handbook, available as a free download at http://www.TOLIHandbook.com.