Tax Consequences for Investors of Life Settlement Policies

by Jane Meggitt

A relatively new form of investment, life settlements are the sale of a policy holder's life insurance policy to a third party. The policy is sold above the cash value, but less than the death benefit. Most sellers are older people, not those with a terminal illness. For seniors, the life settlement option allows unnecessary policies to bring remuneration rather than just permitting them to lapse. However, investors should be aware of tax consequences.

Life Settlements

Life settlements should not be confused with viatical sales. The early market for selling and purchasing active life insurance policies began in the early 1990s, and generally involved patients with AIDS or other terminal illnesses. At that time, the identity of the insured seller was not always kept confidential. Today, the life settlement market is more regulated, and focuses on healthy seniors who no longer have the need for the insurance policy. The Internal Revenue Service (IRS) has also issued decisions regarding life settlement tax treatment.

Eligible Policies

Most types of life insurance policy qualify for life settlements. These include whole life, variable life, adjustable life, universal life, portable group life, survivorship and, joint ownership with a first to die provision. Term life insurance policies may qualify if the policy may be converted and assigned. Not only individually-owned policies are eligible, but also those owned by trusts and corporations. Major financial institutions are the primary purchasers of life settlement policies, such as banks, pension and hedge funds and other institutions investing in life insurance companies.

Tax Consequences for Investors

A 2009 IRS ruling states that the life settlement policy is a capital asset for the investor, but the portion taxable as the death benefit is not treated as a capital gain but as ordinary income. Under IRS ruling 2009-14, if the investor buys the policy for investment purposes and holds it until the insured dies, the amount taxed is equal to the value of the death benefit subtracted from the policy acquisition costs and cost of premiums paid.

Tax Consequences for Policy Holders

For policy holders, sale of the life insurance policy is considered the sale of a capital asset, according to an IRS ruling. This means that the funds received from the policy are taxed as ordinary income, not as capital gains. Legally, the policy holder surrenders the policy to receive the value. According to the American Bar Association, the "excess of the cash surrender proceeds over the cumulative premiums paid is taxed at ordinary income rates rather than lower capital gain rates."

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