Are interest payments on life insurance loans deductible if the loan proceeds were used to purchase an annuity?

[kdhoffman_75]

The annuity established over 10 years ago provides a small amount of income annually.  Annual interest expenses have risen to nearly equal the amount of income.  (Net is approx $100).  

[JulieS]

No, life insurance premiums aren't deductible for individuals no matter what the proceeds are used for. 

[kdhoffman_75]

Clarification:  These are not insurance premiums. The insurance policies are paid in full.  The amount in question is loan interest.  I read in TurboTax that if money is borrowed to fund an investment (in this case to fund an annuity) that the interest on the loan may be deducible as an investment expense.  Loans were taken against the cash value of the policies to purchase the annuity.

Thanks.

[JulieS]

Yes, in general you can deduct investment interest, but this interest isn't deductible because the insurance company looks solely to the cash surrender value of the policy to pay the principal and interest, and no true personal liability arises against the borrower. 

You can't deduct interest on a loan when there is no true personal liability for payment of the loan. 

Here are two Tax Court cases on this matter:

Murray Kay v. Commissioner, 44 T.C. 660, 672 (1965). It is well established, however, that to be deductible, interest must be paid on genuine indebtedness.

In Knetsch v. United States, 364 U.S. 361, 366 (1960), the Supreme Court held that when a loan transaction lacks economic substance, no true indebtedness exists, and interest on such loan is not deductible. A transaction will be determined to be lacking in economic substance, a "sham" transaction, when there is nothing of substance to be realized beyond a tax deduction. See id.; 6 Mertens Law of Federal Income Taxation section 26.10 (1988).