When a policyholder cancels or transfers an insurance policy, there may be certain tax ramifications. 

The adjusted basis of the policy is the amount of the premiums paid for the contract minus any cost-of-insurance charges collected by the insurer. Rev Ruling 2009-13 had laid out several examples that explained the tax treatment when a policyholder surrenders or sells a life insurance contract with and without cash value. The TCJA retroactively added a provision that in determining the basis of a life insurance or annuity contract no adjustment is made for “mortality, expense or other reasonable charges” incurred under the contract. (Sec 1016 (a)(1)(B)) As a result of this change, the cost basis of a life insurance contract is not to be reduced by the cost of insurance.

Note that the effective date of the TCJA amendment is for transactions entered into after August 25, 2009 (not a typo) even though the TCJA wasn’t enacted until Dec. 22, 2017. A change in the IRC that is made retroactive to earlier taxable years does not automatically permit a claim for a refund for such a year when the claim is barred by the period of limitations, and Congress did not amend the statute of limitations or otherwise express an intent to waive or extend the period of limitations for this retroactive change.

Of the income received when a policy is surrendered or sold, the amount equal to the cash surrender value minus the premiums paid is taxed as ordinary income. The excess is long-term capital gain. (Rev. Rul. 2009-13, 2009-21 IRB 1029) For a term life insurance contract without cash surrender value, all of the sale proceeds minus the taxpayer's adjusted basis is taxed as long-term capital gain.

Following are examples from Rev Ruling 2009-13, as modified by Rev Ruling 2020-5 to take into account the TCJA change when appropriate.

Surrender of Policy Example – In Year-1, John enters into a “life insurance contract” with cash value. John is the insured and a member of John’s family was the beneficiary. John had the right to change beneficiaries or surrender the contract for its cash value. In Year-8 John surrenders the contract for its cash value of $78,000 which reflects the subtraction of $10,000 for the “cost of insurance.” John paid total premiums on the policy of $64,000. John was not terminally or chronically ill at the time of the surrender. John’s resulting gain from the sale would be:

Surrender Cash Value: $78,000 (this figure is net of insurance costs)
Paid Premiums           : <64,000>  
Ordinary Income        : $14,000  

Since the surrender of a life insurance contract does not produce capital gain, the income was ordinary income.

Sale of Policy with Cash Value Example (as revised to account for the TCJA change and per Rev Rul 2020-05) - The facts are the same, except that John sells the insurance contract for $80,000 to George who is unrelated to John and who would suffer no economic loss upon John’s death. Here, John’s resulting gain from the sale would be determined as follows:

Contract Sales Price:      $80,000
Paid Premiums : 64,000
Contract Basis               <64,000>
Total Profit:                     $16,000
Ordinary Income            $14,000 (Difference between cash value & paid premiums)
Capital Gains                  $ 2,000 (Balance of gain)  

Prior to the TCJA change, John would have to reduce his basis by the $10,000 “cost of insurance” and his gain would have been $26,000.

To determine the character of the income, the IRS applied the "substitute for ordinary income" doctrine. Application of the substitute for ordinary income doctrine is limited to the amount that would be recognized as ordinary income on surrender of the policy, and income received on sale of a life insurance policy may qualify as gain from the sale of a capital asset to the extent that it exceeds the cash surrender value minus the premiums paid (that is, the "inside build-up" under the contract). Thus, of the income received, the amount equaling the inside buildup on the contract was taxed as ordinary income. The excess was taxed as long-term capital gain.

Sale of Policy without Cash Value Example (as revised to account for the TCJA change and per Rev Rul 2020-05) - The facts are the same, except: the contract is a level premium term life insurance contract without cash surrender value; monthly premiums were $500 per month and through the date of sale John had paid premiums of $45,000; John sold the contract on June 15th (89.5 months into the contract) to Dave (unrelated and who will suffer no economic hardship upon John’s death) for $20,000.

John’s adjusted basis in the contract is equal to the total premiums paid.

Contract Sales Price:  $20,000
Contract Basis            <45,000>  
Capital Loss:               <$25,000>

John won’t be allowed to deduct the loss unless the loss is incurred under Sec 165(c)(1) or (2) (trade or business or entered into for profit other than in a trade or business). Rev. Proc 2020-5 says that John will recognize a $25,000 capital loss.