A life settlement is taxed in three tiers: everything up to your total premiums paid comes back tax-free, the slice between that figure and the policy’s cash surrender value is ordinary income, and anything above cash surrender value is generally long-term capital gain. The single number that determines how much falls into each tier is your investment in the contract, and since 2017 that number is larger — and the tax smaller — than it used to be.
Before you model anything, get two figures from the carrier in writing: total premiums paid since issue, and the current cash surrender value. Without those, any estimate of the tax on an offer is guesswork. The buyer and the carrier will both be reporting numbers to the Internal Revenue Service after closing, so the figures you plan around should be the same ones they will file.
There is one important exception that swallows the whole framework. If the insured is terminally ill, or chronically ill within the statutory definition, the sale can qualify as a viatical settlement and the proceeds may be excluded from gross income entirely under Internal Revenue Code section 101(g). That is a genuinely different outcome, not a smaller tax, and it is the first thing to check.
In This Article
The Three Tiers, Worked Through With Numbers
Assume a universal life policy with a $500,000 death benefit. Total premiums paid since 1999 come to $118,000. The current cash surrender value is $41,000. A buyer offers $145,000.
Tier one — return of basis. The first $118,000 is a tax-free recovery of your investment in the contract. Nothing is owed on it.
Tier two — ordinary income. Here the tier is $0, because the cash surrender value of $41,000 is below basis. Tier two only exists when cash surrender value exceeds your investment in the contract; on this policy it does not, so there is no ordinary income component at all. On a policy where basis is $60,000 and surrender value is $95,000, tier two would be $35,000.
Tier three — long-term capital gain. The remainder, $145,000 minus $118,000, is $27,000 of long-term capital gain, assuming the policy was held more than a year.
Compare that to a surrender. Surrendering the same policy yields $41,000 in cash, generates no taxable income because the surrender value is under basis, and ends the coverage. The settlement produces $104,000 more cash and creates $27,000 of capital gain. That is the comparison worth making — after-tax dollars, not headline offer size. See the settlement versus surrender comparison for the general case.
Why Your Basis Is Bigger Than It Used to Be
For a period, the IRS took the position in Revenue Ruling 2009-13 that a seller’s basis had to be reduced by the cost-of-insurance charges the policy had absorbed over its life. On an old policy that could cut basis substantially and inflate the taxable gain by tens of thousands of dollars.
Section 13521 of the Tax Cuts and Jobs Act of 2017 reversed that. It provides that no basis reduction for mortality, expense, or other reasonable charges is required in determining basis on the sale or surrender of a life insurance contract, and it applied the change retroactively to transactions entered into after August 25, 2009. In plain terms, basis is now generally premiums paid, reduced by amounts previously received tax-free such as dividends taken in cash or applied against premiums, and by prior partial surrenders.
Two adjustments still catch people. If the policy came from a prior section 1035 exchange, basis carries over from the original contract and the current carrier may not have that history — dig up the old records. And if the policy paid dividends that were used to buy paid-up additions rather than taken in cash, those generally did not reduce basis. Our page on calculating cost basis on a life insurance policy walks through the adjustments line by line.
The Forms That Will Arrive
The Tax Cuts and Jobs Act also added Internal Revenue Code section 6050Y, which built a reporting regime around policy sales. Three forms matter.
Form 1099-LS, Reportable Life Insurance Sale. Filed by the buyer, reporting the amount paid to you and the date of sale. You receive a copy.
Form 1099-SB, Seller’s Investment in Life Insurance Contract. Filed by the issuing carrier after it is notified of the sale, reporting your investment in the contract and the policy’s surrender amount. This is the carrier’s official statement of your basis, and it is the figure the IRS will match against your return.
Form 1099-R. Issued for a surrender or a lapse rather than a sale, showing gross distribution and taxable amount.
Read the 1099-SB carefully when it arrives. If the investment-in-the-contract figure looks low — a common problem on policies that changed administrative platforms or came through a carrier merger — request a correction in writing before filing. An understated basis directly overstates your taxable gain. Our overview of the 1099s after a life settlement covers what to check on each box.
| Tier | Amount | Tax Treatment | Example ($500k policy) |
|---|---|---|---|
| Return of basis | Up to investment in the contract | Not taxable | First $118,000 |
| Ordinary income | Basis up to cash surrender value | Ordinary rates | $0 (CSV below basis) |
| Capital gain | Above cash surrender value | Long-term capital gain | $27,000 |
| Viatical (terminal) | Entire proceeds | Generally excluded, IRC 101(g) | $0 taxable |
| Viatical (chronic) | Qualified LTC use, per diem cap | Excluded within limits | Depends on care costs |
| Surrender instead | Cash surrender value | Ordinary income above basis only | $41,000, none taxable |
The Viatical Exception That Can Zero the Bill
Internal Revenue Code section 101(g) treats amounts received on the sale of a policy to a licensed viatical settlement provider as if they were paid by reason of the insured’s death — meaning generally excluded from gross income — when the insured is terminally ill or chronically ill.
Terminally ill means a physician has certified an illness or condition reasonably expected to result in death within 24 months of certification. For a terminally ill insured, the exclusion is generally unlimited.
Chronically ill uses the definition in section 7702B(c): unable to perform at least two activities of daily living without substantial assistance for an expected period of at least 90 days, or requiring substantial supervision due to severe cognitive impairment. For a chronically ill insured the exclusion is narrower — proceeds must be used for qualified long-term care services not compensated by insurance, and per diem style payments are subject to the limitation in section 7702B(d), which was $420 per day for 2025 under the IRS inflation adjustments.
Two conditions are easy to miss. The buyer generally must be a viatical settlement provider licensed in the insured’s state, or meet the alternative requirements in the statute — an unlicensed buyer can cost you the exclusion. And the physician certification has to exist and be documented. See when viatical proceeds are tax-free for the full conditions.
Situations Where the Rules Change
Business-owned policies. A policy owned by a corporation or partnership follows the same three-tier structure, but basis and character are determined at the entity level and the proceeds may affect the owner’s basis in the entity. Employer-owned contracts also have their own notice and consent requirements. Bring your CPA in early.
Trust-owned policies. An irrevocable life insurance trust that sells a policy realizes the gain at the trust level unless the trust is a grantor trust for income tax purposes, in which case it flows to the grantor. Compressed trust tax brackets reach the top rate at a very low income level, so the answer materially changes the tax.
Modified endowment contracts. A policy that failed the seven-pay test under section 7702A has different distribution rules, and prior loans or withdrawals may already have been taxed. The sale itself still follows the three tiers, but the basis history is more complicated.
Transfer-for-value. Section 101(a)(2) can make a death benefit taxable to a buyer who acquired the policy for value, and the Tax Cuts and Jobs Act added the reportable policy sale rules in section 101(a)(3) that limit the old exceptions. This affects the buyer, not you as the seller — but it is why buyers care about the chain of ownership and why selling to a family member privately is more complicated than it sounds.
Every Alternative, and When Selling Is the Wrong Answer
Rank the choices by after-tax result, not headline number.
Keep the policy. No taxable event. The death benefit passes to beneficiaries generally free of income tax under section 101(a). If anyone still depends on the coverage, this usually wins outright.
Reduced paid-up. Generally not a taxable event; you trade a smaller permanent death benefit for no more premiums.
1035 exchange. Tax-deferred move into another policy or an annuity, with basis carrying over. Produces no cash.
Accelerated death benefit rider. Generally excluded from income under section 101(g) for a qualifying insured, with no commission and no third-party buyer. Check the rider schedule before doing anything else.
Surrender. Ordinary income above basis, no capital gain tier, coverage ends.
Life settlement. The three-tier treatment above, generally for face amounts around $100,000 or more.
Selling is the wrong answer when the offer is barely above cash surrender value, because the additional proceeds are the taxed tier and the after-tax gap narrows to very little. It is wrong when the extra income would push you across an IRMAA threshold, disqualify you from a needs-based benefit, or make more of your Social Security taxable — those costs are real and are often overlooked. It is wrong when the insured is chronically or terminally ill and an accelerated death benefit rider would produce tax-free money faster with no transaction at all. And it is wrong whenever a beneficiary still genuinely needs the death benefit.
To see the actual numbers on your policy, send the policy cover page for a free, no-obligation review or call (305) 209-7183, then take the figures to your own CPA. Pine Lake Life Solutions provides educational information only and does not provide legal, tax, or investment advice.
Frequently Asked Questions
Is any part of a life settlement tax-free?
Yes. Proceeds up to your investment in the contract — generally total premiums paid, adjusted for dividends taken in cash and prior withdrawals — come back to you tax-free as a return of basis. Only the amounts above that figure are taxed, split between ordinary income and long-term capital gain.
Did the 2017 tax law make settlements cheaper to sell?
For most sellers, yes. Section 13521 of the Tax Cuts and Jobs Act eliminated the requirement to reduce basis by cost-of-insurance charges, reversing the IRS position in Revenue Ruling 2009-13, and applied it retroactively to transactions after August 25, 2009. Higher basis means less taxable gain on the same offer.
What forms should I expect after closing?
Form 1099-LS from the buyer, reporting what you were paid, and Form 1099-SB from the issuing carrier, reporting your investment in the contract and the surrender amount. Both stem from Internal Revenue Code section 6050Y. Check the basis figure on the 1099-SB against your own records before filing.
How does a viatical settlement differ for taxes?
If the insured is terminally ill, certified by a physician as expected to die within 24 months, proceeds paid by a licensed viatical settlement provider are generally excluded from income under section 101(g). For a chronically ill insured the exclusion is narrower and tied to qualified long-term care expenses and a statutory per diem limit.
Does a policy loan change the tax on a sale?
Yes. The loan is generally repaid out of the sale proceeds at closing, and the discharged loan counts toward the amount you are treated as receiving. That can create taxable gain larger than the cash you actually take home, so ask for both the gross offer and the net-to-you figure early.
Is a trust-owned policy taxed differently?
Often. If the trust is a grantor trust for income tax purposes, the gain generally flows to the grantor’s return. If not, the trust reports it, and trust tax brackets reach the top rate at a very low income level. Confirm the trust’s income tax status with the drafting attorney before selling.
Do I owe state tax too?
Usually. Most states begin with federal adjusted gross income, so the same tiers carry through to the state return. Rates range from zero in states with no individual income tax to over 13% in California. A handful of states exclude part of long-term capital gain.
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Related Reading
- Are Life Settlement Proceeds Taxable
- Life Settlement Tax Basis Explained
- Tcja Life Settlement Tax Rules Explained
- 1099 After Life Settlement
- Viatical Tax Exclusion Rules
- State Income Tax On Settlement
- Cost Basis Life Insurance Policy
- Life Settlement Vs Cash Surrender Value
- Cpa Review Before Selling
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.