A life insurance policy is like the proverbial pot of gold at the end of the rainbow.
But in the case of term life insurance policies, collecting that pot of gold can prove elusive. If the insured dies after the policy term (typically 10 to 30 years) ends, the beneficiaries get nothing. In fact, most term policies never pay any death benefits.
Purchasing an existing term policy from the insured as an investment is incredibly risky for the buyer—they’ll end up with nothing if the insured lives too long. For this reason, investors in the business of purchasing life insurance policies seldom purchase term policies unless they can be converted into permanent insurance, such as whole life.
The only exception is where the insured is terminally ill and highly unlikely to outlive the policy term.
The Story of Uncle Bob
You might be able to sell your term life insurance policy to a relative or another individual not in the business of buying life insurance policies. Consider the following example.
Uncle Bob has had, for several years, a $1 million term life insurance policy that is not convertible to whole life or other permanent insurance. The policy term has 10 years left. Uncle Bob is a widower and has no children. His nephew, Joe, offers Uncle Bob $10,000 and promises to pay the rest of the premiums if Bob makes Joe the beneficiary.
As you’d expect, such a transaction has tax consequences as you’ll see in the answers to the three questions below.
Question 1: How Does Uncle Bob Treat His $10,000 Payment from Joe?
Although the transaction seems rather informal, the economic substance is that Uncle Bob received $10,000 in exchange for the valuable future rights to a $1 million death benefit. It’s likely that the IRS and courts would view this as a transfer for valuable consideration.
In the life insurance context, a “transfer for valuable consideration” means any transfer of an interest in a life insurance contract for cash or other consideration reducible to a money value.1Thus, for example, the IRS ruled that there was a transfer for value when a couple’s children paid them a nominal amount and agreed to pay all future premiums on the couple’s life insurance policy in return for a share of the death benefit.2
Whether Uncle Bob has taxable gain on his $10,000 payment from Joe depends on his basis in his policy. Bob’s basis is equal to the premiums he paid prior to the transfer to Joe. This istrue even though the premiums only provided insurance protection, not basis in a cash value account.3
Thus, if Bob paid $10,000 or more in premiums, he will have no taxable gain. If, for example, he paid $5,000 in premiums, he’ll have $5,000 in taxable income. Because this is a term policy with no cash surrender value and Bob has owned the policy for more than one year, the entire amount would be taxed as a long- term capital gain.4
Question 2: If Uncle Bob Dies within 10 Years, How Will Joe’s $1 Million Death Benefit Be Taxed?
Ordinarily, life insurance death benefits are tax-free.5 But this is not the case when a policy is purchased for valuable consideration. In this event, the death benefits paid on the policy are excluded from income only up to the amount paid for the policy plus any premiums paid after the transfer.6
There are some exceptions to the transfer-for-value rule—transfer to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer—but none of them apply here.7
Joe paid $10,000 for the policy. If Joe also pays $10,000 in premiums, $20,000 of the death benefit will be excluded from income. His taxable income upon Bob’s death will be $980,000. This is taxed as ordinary income, not capital gain.8
Question 3: If Uncle Bob Doesn’t Die within 10 Years?
A life insurance policy is a capital asset. Does this mean that Joe has a
$10,000 capital loss? Likely not.
A term life insurance policy is not like a whole life policy with cash value. It has no property-like investment attributes that accrue over time. Once it expires, it’s economically worthless.
When a term policy expires, there is no sale, exchange, or other fixed identifiable event that the IRS recognizes for deduction.9 The “mortality loss” attributable to Uncle Bob’s longevity is not a recognized loss for tax purposes.10
Can Joe deduct the premiums he paid? No. Taxpayers cannot deduct the premiums they pay for a life insurance policy if they are a beneficiary of the policy.11
Takeaways
Here are three takeaways from this article:
- When the insured transfers a life insurance policy death benefit for valuable consideration, he or she will have taxable income to the extent the payment received exceeds the insured’s basis in the policy—the premiums paid before the transfer.
- When a life insurance policy is purchased for valuable consideration, the death benefits paid are excluded from income only up to the amount paid for the policyplus any premiums paid after the transfer.
- There is no deductible loss when a term life insurance policy expires.
1 Reg. Section 1.101-1(f)(5).
2 PLR 199903020.
3 IRC Section 1016(a)(1) (B ); Rev. Rul. 2020-5.
4 Rev. Rul. 2009-13.
5 IRC Section 101(a)(1).
6 IRC Section 101(a)(2).
7 Reg. Section 101-1(b)(1)(ii) (B )(1).
8 Rev. Rul. 2009-14.
9 Reg. Section 1.165-1(c)(3).
10 Rev. Rul. 56-634.
11 IRC Section 264(a)(1).