Texas residents who sell a life insurance policy pay federal tax on part of the proceeds under a three-layer framework — but no state income tax at all, because Texas has none as of 2026. That single fact makes Texas one of the most tax-favorable states in the country for a life settlement: the only rules you and your accountant need to work through are the federal ones.
The federal framework, clarified after the Tax Cuts and Jobs Act and in IRS Revenue Ruling 2020-05, splits your sale price into three layers: a tax-free return of the premiums you paid, an ordinary-income layer up to the policy’s cash surrender value, and a capital-gain layer for anything above that. Viatical settlements — sales by terminally ill insureds with a life expectancy under 24 months — are generally income-tax-free altogether under Section 101(g) of the tax code.
This guide walks through each layer with a worked dollar example, explains the viatical exception, and flags the records you need. It is education, not tax advice — bring your actual numbers to a CPA or tax attorney before you close.
In This Article
The Federal Three-Layer Framework
When you sell a policy for more than you paid into it, the IRS does not treat the whole check as income. Under the post-TCJA rules confirmed in Rev. Rul. 2020-05, the sale price is divided into three layers, applied in order:
- Layer 1 — return of basis (tax-free). Everything up to the total premiums you paid over the life of the policy comes back to you free of tax. Notably, TCJA ended the old requirement to reduce basis by the cost of insurance — your basis is generally your cumulative premiums.
- Layer 2 — ordinary income. The portion of the price above your basis, up to the policy’s cash surrender value, is taxed as ordinary income — the same treatment you would get on that amount if you surrendered.
- Layer 3 — capital gain. Anything you receive above the cash surrender value is capital gain, and for a policy held more than a year it is long-term capital gain, which federal law taxes at lower rates than ordinary income.
Understanding your policy’s cash surrender value is therefore essential — it is the boundary line between the ordinary-income and capital-gain layers.
A Worked Example for a Texas Seller
Suppose a 74-year-old Houston policyowner sells a $400,000 universal life policy. Over the years she paid $60,000 in premiums (her basis). The policy’s cash surrender value is $75,000, and a settlement provider pays $120,000. The layers fall out like this:
- $60,000 (up to basis) — tax-free return of premiums.
- $15,000 ($75,000 CSV minus $60,000 basis) — ordinary income on her federal return.
- $45,000 ($120,000 price minus $75,000 CSV) — long-term capital gain.
Her total federal taxable amount is $60,000, split between two rate schedules — and her Texas tax on the sale is zero. Compare that with the alternative: surrendering for $75,000 would have produced $15,000 of ordinary income and left $45,000 of value on the table entirely. The side-by-side economics are covered in life settlement vs. surrender. Every real case differs — loans against the policy, dividends, and 1035 exchanges can all shift basis — which is why the example is illustrative only.
Why Texas’s Lack of an Income Tax Matters
As of 2026 Texas remains one of the handful of states with no personal income tax, and the Texas Constitution makes adopting one deliberately difficult. For a life settlement, that means the ordinary-income and capital-gain layers are taxed once — federally — and not again by the state.
The dollar impact is real. In a state with a 5% income tax, the seller in our example above could owe roughly $3,000 more in state tax on her $60,000 of taxable layers (the exact figure depends on how the state treats capital gains). A Texas seller keeps that. When comparing a settlement against other ways to raise funds — a policy loan, a reverse mortgage, drawing down an IRA (whose distributions are also free of Texas state tax but fully federally taxable) — run the after-tax numbers, not the sticker prices, and let a professional check the math.
| Layer of Sale Price | Federal Tax Treatment (2026) | Texas State Tax |
|---|---|---|
| Up to premium basis | Tax-free return of basis | None — no state income tax |
| Basis up to cash surrender value | Ordinary income | None |
| Above cash surrender value | Capital gain (long-term if held over 1 year) | None |
| Viatical (life expectancy under 24 months) | Generally income-tax-free under IRC Sec. 101(g) | None |
| Surrender instead of sale | Ordinary income on CSV above basis | None |
The Viatical Exception: Terminally Ill Sellers
Federal law carves out a major exception. Under IRC Section 101(g), if the insured is terminally ill — generally certified by a physician as having a life expectancy of 24 months or less — the proceeds of a viatical settlement are treated like a death benefit and are generally free of federal income tax entirely. Sales by chronically ill insureds can also qualify for favorable treatment when the proceeds are used for qualified long-term-care costs, subject to additional requirements.
Two practical cautions. First, the exemption has technical conditions — including, in regulated contexts, that the buyer meet certain licensing or qualification standards — so the identity and status of the purchaser can affect your tax outcome. Second, the physician certification must meet the statute’s definition. If illness is part of your situation, tell your tax professional early; the difference between a taxable settlement and a tax-free viatical can be tens of thousands of dollars.
Records That Determine Your Tax Bill
Your tax outcome is only as accurate as your paperwork. Before closing, gather:
- Premium history. Your cumulative premiums are your basis. The insurer can produce a payment history if your own records are incomplete.
- A current statement showing cash surrender value. This sets the ordinary-income boundary.
- Form 1099-LS. The buyer reports the acquisition to the IRS and to you; the insurer may also issue Form 1099-SB showing your basis. Keep both with your return.
- Loan and withdrawal history. Outstanding policy loans and prior withdrawals can change both your basis and your net proceeds.
If the policy went through a 1035 exchange from an older contract, basis carries over from the original policy — bring the old records too. Which policies are marketable in the first place is a separate screen, covered in what policies qualify for a life settlement.
Settlements, Medicaid, and Timing
Taxes are not the only system that notices a settlement. If long-term care is on the horizon, remember that Medicaid counts assets, and converting a policy into cash at fair market value changes your countable-asset picture — usually deliberately, as part of a compliant spend-down. Texas’s income-cap rules and Miller Trust requirement add a wrinkle federal taxes do not, so read our guide to Texas Medicaid asset and income limits alongside this one, and involve an elder law attorney if a Medicaid application is within five years of plausible.
Timing can matter federally, too. A settlement’s ordinary-income layer lands in the year of sale and can push you into a higher bracket, affect the taxation of Social Security benefits, or trigger higher Medicare premiums (IRMAA) two years later. These are planning questions, not reasons to avoid a sale — but they belong on the table before you sign.
Getting Real Numbers for Your Policy
The tax analysis only matters once you know what your policy might actually bring. Market-wide, the GAO’s study of settlements (GAO-10-775) found sellers typically received about 10% to 35% of face value — roughly 4 to 8 times cash surrender value — with the process running 60 to 120 days. A free policy review starts with just your policy’s cover page and tells you whether yours is a realistic candidate; your right to sell it at all traces back to Grigsby v. Russell. Call (305) 209-7183, or keep reading in the Education Center. Then take the projected numbers to your CPA — this guide describes the rules but is not tax advice.
Frequently Asked Questions
Do I pay Texas state tax on a life settlement?
No. Texas has no personal income tax as of 2026, so only federal rules apply to your proceeds. That gives Texas sellers a real edge over residents of states that layer income tax on top of the federal treatment.
How does the IRS tax a life settlement in 2026?
In three layers. Amounts up to your total premiums paid come back tax-free, the portion above that up to the policy’s cash surrender value is ordinary income, and anything above cash surrender value is capital gain. These rules follow the Tax Cuts and Jobs Act and IRS Revenue Ruling 2020-05.
Are viatical settlements tax-free?
Generally yes. Under Section 101(g) of the tax code, proceeds from a sale by a terminally ill insured — typically a certified life expectancy of 24 months or less — are treated like a death benefit and escape federal income tax. Technical conditions apply, including requirements about the buyer, so confirm your facts with a tax professional.
What counts as my basis in the policy?
Generally the total premiums you have paid over the life of the policy. Since the Tax Cuts and Jobs Act, you no longer reduce basis by the cost of insurance for settlement purposes. Policy loans, withdrawals, and 1035 exchanges can adjust the figure, so pull the insurer’s full payment history.
Is selling taxed worse than surrendering?
Not on the overlapping layers. The ordinary-income treatment up to cash surrender value is the same either way; a sale simply adds a capital-gain layer on the extra amount a buyer pays above CSV — money a surrender never produces. Most sellers net more after tax by selling, but run your own numbers with a professional.
Will the sale be reported to the IRS?
Yes. The buyer files Form 1099-LS reporting the acquisition, and your insurer may issue Form 1099-SB showing your basis. Keep both forms with your tax records and give them to your preparer for the year of sale.
Could a settlement raise my Medicare premiums or tax on Social Security?
It can. The taxable layers count as income in the year of sale, which can increase the taxed share of your Social Security benefits and can trigger higher income-related Medicare premiums about two years later. A tax professional can help you weigh timing before you close.
Does a life settlement affect Medicaid eligibility in Texas?
It converts a countable asset into cash, which you must then handle under Texas’s Medicaid rules — including the state’s income-cap and Miller Trust structure — if a long-term-care application is coming. Selling at fair market value is not a gifting violation, but sequence the steps with an elder law attorney.
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Related Reading
- Life Settlement Vs Surrender
- Cash Surrender Value Life Insurance
- What Policies Qualify For Life Settlement
- Grigsby V Russell Explained
- Texas Medicaid Asset Income Limits
- Life Settlement Licensing Texas
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.