How to determine cost basis for 1099B on life policy cashout?

[pow1213]

Policy was opened by mother in early 60's.   

[ScruffyCurmudgeon]

The cost basis inthe policy is the sum of all your insurance payments. If your cashvalue balance is higher than the amount you paid in premiums, the remaining money represents your taxable gains.

Your question suggested that your mother is still alive and that you or she intend to "surrender" the policy.

The surrendering of an existing in-force life insurance policy back to the underwriting company or the sale of that same policy to a third-party, typically an investor who will hold the policy for the purposes of obtaining ultimately the death benefit, are taxable events.  Since you chose the second approach to obtain value that had built up in your policy, this answer only covers that second alternative which is technically called a Life Settlement.

Before going further,  please be advised that the Tax Cuts and Jobs Act of 2017, overrode the previous guidance on the taxation of life settlements under IRS Revenue Ruling 2009-13.)  That is to say, anything you might have understood about the Cost Basis calculation used in either a surrender or a life settlement done prior to 2017 is no longer valid.

The sale of a life insurance policy is a taxable event and the characterization of gains is determined under the guidelines set out in IRS Revenue Ruling 2009-13 by the Tax Cuts and Jobs Act (TCJA) of 2017. 

The sale or surrendering of an in-force life insurance policy creates a tax liability because, from the IRS perspective, the policy has a calculable cost (the "Cost Basis"), as if it were an investment, and has obviously a sale value shown by the proceeds that you receive. 

NOTE: "Term Life" policies do not build up a cash value so this question and answer is not relevant to term life policies.

Here is an example to illustrate the effect of taxation of a sale of an in-force policy that has built up cash value:

• Cash surrender value of $66,000 as stated by insurance company
• Total premiums paid of $58,000 
• The policy has been owned for 10 years, has had no withdrawals, and has had no loans
  
• The individual insured is not terminally or chronically ill
• The policy is sold for $75,000 in a life settlement transaction

Prior to TCJA (2017), the cost basis as determined in IRS Ruling 2009-13 would have been the premiums paid reduced by the insurance company’s record of the internal cost-of-insurance charges  - as an example $10,000 so the calculation would have then been ($58,000 – $10,000 = $48,000). 

However, TCJA repealed this interpretation, and instead the cost basis is simply the total premiums paid ($58,000).

Tax liability calculation:   Proceeds of Sale less Cost Basis = $75,000 minus $58,000 = $17,000 taxable

Now, since TCJA (2017) the determination of what is taxable and at what rate becomes more complex.

Of the taxable income (in this example, $17,000), the portion that is the policy’s internal “profit” (the excess of the available cash surrender value over premiums paid) is taxed as ordinary income. 

• Cash surrender value of $66,000 less Total premiums paid of $58,000  = $8,000

The remaining gain that the sale generated, $9,000,  is treated as a gain on property interest and is taxed at capital gains rates.

So this example of a sale would generate two separate taxable reported events:

• Form 1099-MISC Box 3   $8,000 taxed as ordinary income, not subject to employment taxes
• Form 1099-B  Gain of $9,000 to be reported as a Long-Term investment gain.

Hope this helps to clear up any question.