If you sell a life insurance policy to a third party, the tax consequences will depend on
the amount paid and the your cost basis in the policy. Your cost basis, in turn, generally
will be the amount of premiums paid less any amounts surrendered or cash dividends
received.
For example, Ted Smith has been covered by a $200,000 life insurance policy. Ted feels this
coverage no longer is necessary.
Suppose a buyer, after looking at Ted’s medical history and estimating his life expectancy,
offers $30,000 for the policy.
Ted has paid $30,000 in premiums and there have been neither surrenders nor dividends, so
the basis is $30,000.
With a $30,000 basis and a $30,000 purchase price, no taxes will be due. If Ted had paid
only $20,000 in premiums, for a $20,000 basis, taxes would be due on $10,000 of income, on
a sale for $30,000.
What tax rates would apply to that income? That depends on the nature of the policy.
ordinary income, taxed up to 35 percent. Any excess qualifies for the bargain 15 percent
rate on capital gains.
Suppose $20,000 had been paid in premiums, the cash value was $22,000, and the purchase
price was $30,000. Of the $10,000 gain, in this example, the first $2,000 of gain ($22,000
cash value minus the $20,000 basis) will be taxed as ordinary income while the remaining
$8,000 would be a long-term capital gain.
ordinary income or capital gains rates apply. You might take an aggressive position and
report all the taxable income as a long-term capital gain.