If you own a life insurance policy and sell it, you may realize gain on the transaction. The Tax Cuts and Jobs Act (TCJA) changed the rules for determining basis used in measuring gain from such a sale. It is no longer necessary to reduce basis by the cost of the life insurance protection (mortality, expense, or other reasonable charges incurred in the contract). Now the IRS has provided examples explaining the impact of the change (Rev. Rul. 2020-5).
Pre-TCJA
In Rev. Rul. 2009-13, the IRS provided two examples of how the old rules worked.
A, an individual, entered into a life insurance contract with cash value on January 1 of Year 1. Under the contract, A was the insured, and the named beneficiary was a member of A’s family. On June 15 of Year 8, A sold the contract to B, an unrelated person who would suffer no economic loss upon A’s death, for $80,000. Prior to the sale of the contract, A had paid $64,000 in premiums. The cost of insurance charges collected by the issuer was $10,000 as of the date of the sale. Under pre-TCJA rules, A was required to reduce basis by the portion of the premium paid for the contract that was expended for the provision of insurance before the sale in order to measure the taxpayer’s gain upon the sale of the contract. Therefore, A must reduce A’s basis in the contract by the cost of insurance. As a result, A’s adjusted basis as of the date of the sale was $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance). Because A sold the contract for $80,000, A must recognize $26,000 of income on the sale of the contract ($80,000 amount realized less $54,000 adjusted basis of the contract).
In another situation, the contract was a level premium 15-year term life insurance contract without cash surrender value. The monthly premium for the term life insurance contract was $500, A held the contract for 89.5 months, and A paid premiums totaling $45,000 as of the date of the sale. A sold the contract for $20,000 to B, an unrelated person who would suffer no economic loss upon A’s death. A must reduce A’s basis in the contract by the cost of insurance, which is presumed to equal the monthly premiums under the contract for the 89.5 month holding period. A’s adjusted basis in the contract as of the date of the sale was therefore $250 ($45,000 total premiums paid less $44,750 cost of insurance protection for 89.5 months). Because A sold the contract for $20,000, A must recognize $19,750 of income on the sale of the term life insurance contract ($20,000 amount realized on the sale less $250 adjusted basis of the contract).
Post-TCJA
The IRS has revisited these situations and changed the outcome in each because under the TCJA, the cost basis of a life insurance contract is not reduced by the cost of insurance regardless of why the contract was purchased. In the first situation, basis does not have to be reduced by the $10,000 expended for insurance. As a result, gain is effectively reduced by $10,000 to $16,000. In the second situation, A’s basis equals the premiums paid with no reduction and therefore A realizes a loss of $25,000 ($45,000 basis less $20,000 amount received), rather than a gain of $19,750. The loss is not deductible unless it can be shown that the loss was incurred in a trade or business or in a transaction entered into for profit.