What’s Your Basis When You Sell a Life Insurance Policy? (w/Examples) + FAQs

This article reflects federal rules and general state guidance as of June 2026 and covers tax year 2025 (the 2026 filing season). Tax law changes — confirm current figures before you file.

Quick Answer

Your basis is the total premiums you paid into the policy, not reduced by the cost of insurance, under IRS Rev. Rul. 2020-05. When you sell, the proceeds up to that basis are tax-free, the part up to your cash surrender value is ordinary income, and any amount above that is capital gain — unless a viatical exclusion applies.

When you sell a life insurance policy to an investor in a life settlement, the IRS treats it like selling property, and your basis is the number that decides how much of the check is taxed and how much you keep. Getting that number wrong is the difference between a clean return and an IRS notice, because the buyer files a Form 1099-LS that tells the IRS exactly what you were paid.

The stakes are real and growing. The Life Insurance Settlement Association reports the U.S. secondary market topped $1 billion in face value of policies sold in a single recent year, and most sellers are over age 65 settling a policy they no longer need. If you sell, the basis figure drives a three-layer tax that you must report yourself — the IRS will not compute it for you.

Here is what you will learn:

• 💵 How to calculate your exact basis using the current “premiums paid” rule.
• 🧱 The three-layer tax stack — tax-free, ordinary income, and capital gain — with the math worked out.
• 🩺 When a viatical or chronic-illness sale is fully tax-free under IRC § 101(g).
• 📄 Which forms report the sale (1099-LS, 1099-SB, 8949, Schedule D) and the traps inside each.
• ⚠️ The costly mistakes — like subtracting cost of insurance — that trigger overpayment or an audit.

What “Basis” Means in a Life Insurance Sale

Basis is your investment in the policy — the money you have already been taxed on, so you should not be taxed on it again. In plain terms, your basis is the total of all premiums you have paid into the contract over its life, minus any amounts you already pulled out tax-free, such as prior dividends taken in cash or partial withdrawals.

The reason basis matters is simple: gain equals what you receive minus your basis. A higher basis means a smaller taxable gain, and a smaller tax bill. If you understate your basis, you pay tax you do not owe. If you overstate it, you underpay and risk a penalty when the buyer’s Form 1099-LS reports a sale price that does not match your math.

For most of tax history this seemed straightforward, but the IRS muddied it in 2009 and then cleaned it up in 2020. The current, controlling rule is the one you must use, and it is more favorable to sellers than the old one. Knowing which rule applies — and to which tax year — is the single most valuable thing in this guide.

The Rule That Changed: Cost of Insurance Is Back In Your Basis

For roughly a decade, sellers had to reduce their basis by the policy’s cost of insurance — the internal charge the insurer takes each year to cover the pure death-benefit risk. That came from Rev. Rul. 2009-13, which said your basis on a sale equals total premiums paid less charges for the provision of insurance. That subtraction shrank basis and inflated taxable gain for thousands of sellers.

The Tax Cuts and Jobs Act of 2017 reversed this. Congress added § 1016(a)(1)(B), and the IRS confirmed the change in Rev. Rul. 2020-05, which holds that the cost basis of a life insurance contract is not reduced by the cost of insurance, regardless of why the policy was bought. The change applies to sales after August 25, 2009 — meaning even some older sales could be amended.

The consequence is direct money in your pocket. Under the old rule, a policy with high internal insurance charges had a tiny basis and a large taxable gain. Under the current rule, your basis is the full premiums you paid, so your gain is smaller and your tax is lower.

A common misconception still circulates online that you must subtract cost of insurance — older articles and even some preparers repeat the dead 2009 rule. That is wrong for any sale today. What you should do: use total premiums paid as your basis, and if you sold a policy after 2009 and were taxed under the old subtraction rule, ask a CPA whether amending an open year is worth it.

Basis Treatment	Tax Result for the Seller
Old rule — Rev. Rul. 2009-13 (subtract cost of insurance)	Lower basis, larger taxable gain, higher tax bill
Current rule — Rev. Rul. 2020-05 (no subtraction)	Higher basis, smaller taxable gain, lower tax bill

The Three-Layer Tax Stack on a Life Settlement

When you sell a policy in a life settlement (the insured is not terminally or chronically ill), the IRS splits your proceeds into three layers, each taxed differently. This framework comes straight from Rev. Rul. 2009-13 and survives today, only with the friendlier basis number from 2020.

The first layer is your basis (premiums paid). Proceeds up to this amount are a tax-free return of your own money. The second layer runs from your basis up to your cash surrender value; this slice is taxed as ordinary income, because it reflects the policy’s “inside buildup” of investment earnings you never paid tax on. The third layer is everything above the cash surrender value, taxed as long-term capital gain, because it reflects the market premium an investor pays for a policy worth more sold than surrendered.

The why behind the split: ordinary income covers the part you would have owed tax on if you had simply cashed the policy in with the insurer, and capital gain covers the extra the open market is willing to pay. What you should do: get three numbers in writing before you sell — total premiums paid, current cash surrender value, and the offered sale price — because those three drive every dollar of tax.

Proceeds Layer	How It Is Taxed
Amount up to your basis (premiums paid)	Tax-free return of capital
Basis up to cash surrender value	Ordinary income (inside buildup)
Anything above cash surrender value	Long-term capital gain

Worked Example: A Universal Life Policy Sold in 2025

Meet Carol, age 70, who owns a universal life policy with a $500,000 death benefit. Over 22 years she paid $120,000 in premiums. Her current cash surrender value is $90,000, and a life settlement provider offers her $170,000 in 2025. She is healthy, so this is a life settlement, not a viatical sale.

Here is the math, layer by layer:

• Basis (premiums paid): $120,000 — tax-free.
• Ordinary income layer: cash surrender value $90,000 minus basis $120,000 = $0, because her basis exceeds her cash value, so there is no inside-buildup gain.
• Capital gain layer: sale price $170,000 minus the greater of basis or cash value ($120,000) = $50,000 long-term capital gain.

So of Carol’s $170,000 check, $120,000 is tax-free and $50,000 is long-term capital gain. At a 15% federal capital-gains rate, she owes about $7,500 in federal tax and keeps roughly $162,500. Had she used the dead 2009 rule and cut her basis by, say, $40,000 of insurance charges, her ordinary-income and gain layers would have ballooned and her tax could have more than doubled — the exact trap Rev. Rul. 2020-05 protects her from.

Worked Example: A Whole Life Policy With Inside Buildup

Now meet James, age 68, who owns a whole life policy. He paid $80,000 in premiums, his cash surrender value is $110,000, and an investor offers him $150,000 in 2025. Here the cash value is higher than his basis, so the ordinary-income layer is live.

• Basis: $80,000 — tax-free.
• Ordinary income layer: cash value $110,000 minus basis $80,000 = $30,000 ordinary income.
• Capital gain layer: sale price $150,000 minus cash value $110,000 = $40,000 long-term capital gain.

James reports $30,000 as ordinary income (taxed at his marginal rate, say 24% = about $7,200) and $40,000 as long-term capital gain (15% = $6,000), for roughly $13,200 in federal tax on a $150,000 sale. The lesson: whole life policies with strong cash value usually trigger the middle ordinary-income layer, while term policies — which build little or no cash value — usually produce almost pure capital gain.

The Viatical Exception: When the Sale Is Tax-Free

If the insured is terminally ill or chronically ill, the rules flip in the seller’s favor. Under IRC § 101(g), proceeds from selling a policy on a terminally or chronically ill insured to a qualified viatical settlement provider are treated as paid “by reason of the death of the insured” — which means they are generally excluded from gross income entirely.

“Terminally ill” means a physician certifies a life expectancy of 24 months or less, and the exclusion is unlimited. “Chronically ill” tracks the long-term-care definition in § 7702B(c)(2), and the exclusion is limited and usually requires the proceeds be used for qualified long-term-care costs. Meet Diane, age 60, certified terminally ill, who sells her $300,000 policy for $210,000 to a licensed viatical provider; under § 101(g), all $210,000 is federally tax-free, and basis is irrelevant.

The consequence of getting the provider wrong is severe: the exclusion generally applies only when the buyer is a licensed viatical settlement provider meeting the requirements in Rev. Rul. 2002-82 and applicable state law. A common misconception is that any terminal diagnosis makes any sale tax-free — it does not. What you should do: confirm the buyer’s viatical license, get the physician certification in writing, and keep both with your tax records.

Which Situation Applies to You?

The tax depends on who is insured and how sick they are, so find your branch before you do any math:

• You are healthy and selling to an investor: this is a life settlement — use the three-layer stack (tax-free / ordinary / capital gain).
• The insured is terminally ill (24 months or less): this is a viatical sale — proceeds are generally fully tax-free under § 101(g).
• The insured is chronically ill: partial § 101(g) exclusion, often tied to long-term-care spending — confirm limits.
• You surrender the policy to the insurer instead of selling: no capital-gain layer; gain above basis is all ordinary income on a Form 1099-R.
• You sell a term policy with no cash value: almost the entire gain is long-term capital gain.

Surrender vs. Sale: They Are Taxed Differently

People often confuse surrendering a policy with selling it, but the tax is not the same. If you surrender to your insurer, you get the cash surrender value, and any amount above your basis is taxed entirely as ordinary income — there is no capital-gain layer because there is no market sale. The insurer reports it on a Form 1099-R.

If you sell to a third-party investor, the price usually beats the surrender value, and the excess over cash value becomes long-term capital gain, which is taxed at lower rates. That is the core appeal of a life settlement: you typically collect more cash and a chunk of it is taxed at favorable capital-gains rates instead of ordinary rates.

The consequence of defaulting to surrender is leaving money on the table — both a lower price and a worse tax character. What you should do: before surrendering, get a life settlement appraisal; if the offer beats the surrender value after tax, selling usually wins.

Exit Method	Tax Character of the Gain
Surrender to the insurer	All gain above basis is ordinary income (Form 1099-R)
Sell to an investor (life settlement)	Inside buildup is ordinary; excess over cash value is capital gain

How the Sale Gets Reported: Forms and Deadlines

A life settlement is a reportable policy sale, which triggers an information-reporting chain under IRC § 6050Y. You will not file all these forms yourself, but you must know what lands in the IRS’s hands so your return matches.

The buyer (acquirer) files Form 1099-LS, reporting the amount paid to you, your TIN, the issuer, and the policy number — generally furnished to you by February 15 following the year of sale. The insurer (issuer) files Form 1099-SB, reporting your investment in the contract (your basis) and the surrender value, which is how the IRS cross-checks your numbers. You then report the sale on Form 8949 and carry the totals to Schedule D for the capital-gain layer, and any ordinary-income layer goes on Schedule 1 of your Form 1040.

The deadline is your normal filing date — April 15, 2026 for a 2025 sale — and missing it or ignoring the 1099-LS invites an underreporter notice (CP2000) plus interest and penalties. What you should do: reconcile the 1099-LS and 1099-SB against your own premium records the moment they arrive, and fix discrepancies before you file.

The Transfer-for-Value Trap (Mostly for Buyers, But Know It)

The transfer-for-value rule in IRC § 101(a)(2) can turn an otherwise tax-free death benefit into taxable income for whoever ends up owning the policy. When a policy is sold for valuable consideration, the buyer’s eventual death-benefit payout can become taxable above what they paid plus later premiums — the opposite of the usual income-tax-free death benefit.

This rarely hits the original seller, who is taxed on the sale itself, but it matters if you are buying a policy or transferring one within a family or business. Exceptions exist — transfers to the insured, to a partner of the insured, to a partnership or corporation in which the insured is an owner, and certain carryover-basis transfers. What you should do: if a policy changes hands for money outside those exceptions, have a tax attorney confirm the death benefit stays tax-free before the deal closes.

Mistakes to Avoid

• Subtracting cost of insurance from basis — uses the dead 2009 rule, overstates your gain, and makes you overpay tax.
• Forgetting prior tax-free withdrawals or loans — these reduce basis, and ignoring them understates gain and risks a penalty.
• Confusing surrender value with sale price — they create different layers; mixing them produces a wrong taxable amount.
• Assuming a terminal diagnosis makes any sale tax-free — the § 101(g) exclusion requires a licensed viatical provider and certification.
• Ignoring the Form 1099-LS — the IRS already has it, so omitting the sale guarantees a CP2000 notice.
• Treating the whole check as capital gain — the inside-buildup layer is ordinary income on a whole or universal life policy.
• Skipping state tax — most states tax the gain too, and a few tax viatical proceeds your federal return excludes.
• Selling before checking outstanding policy loans — a loan payoff at sale can create unexpected taxable “phantom” income.

Do’s and Don’ts

• Do gather total premiums paid, cash surrender value, and the sale offer before signing — they drive every tax layer.
• Do keep the Form 1099-LS and 1099-SB and reconcile them to your records, because the IRS matches them.
• Do verify a viatical buyer’s license, since the § 101(g) exclusion depends on it.
• Do compare an after-tax sale to a surrender, because the sale usually nets more and is taxed better.
• Do call a CPA when cash value exceeds basis, because the ordinary-income layer is easy to miscompute.
• Don’t subtract cost of insurance from basis — that rule died with Rev. Rul. 2020-05.
• Don’t assume your state follows federal treatment, because conformity varies.
• Don’t ignore policy loans, which can inflate your taxable gain at sale.
• Don’t treat a chronic-illness sale as unlimited tax-free — the exclusion is capped.
• Don’t file without the buyer’s reported sale figure, or your return will not match the 1099-LS.

Pros and Cons of Selling Your Policy

• Pro: you typically get more than the surrender value, because investors price in the death benefit.
• Pro: part of the gain is long-term capital gain, taxed below ordinary rates.
• Pro: the basis (premiums paid) layer comes back to you tax-free.
• Pro: a viatical sale for a terminally ill insured can be fully tax-free under § 101(g).
• Pro: you stop paying premiums on a policy you no longer need.
• Con: the inside-buildup layer is taxed as ordinary income on cash-value policies.
• Con: you lose the death benefit your heirs would have received income-tax-free.
• Con: the sale is reported to the IRS, so it cannot be left off your return.
• Con: state tax and possible loss of means-tested benefits (like Medicaid) can erode the proceeds.
• Con: broker commissions and provider fees reduce your net check.

What to Do Next

1. Request your basis (total premiums paid) and cash surrender value in writing from your insurer — ask for the Form 1099-SB figures.
2. Get a life settlement appraisal and compare the after-tax offer to a straight surrender.
3. If the insured is ill, confirm the buyer is a licensed viatical provider and obtain the physician certification.
4. After the sale, collect the Form 1099-LS and reconcile it to your records before filing.
5. Report the capital-gain layer on Form 8949 and Schedule D and any ordinary-income layer on Schedule 1 by April 15, 2026 for a 2025 sale.
6. Call a CPA or tax attorney if cash value exceeds basis, if a policy loan is outstanding, or if the transfer-for-value rule may apply — this is the point where mistakes get expensive.

This guide is educational and is not a substitute for advice from a licensed CPA, tax attorney, or financial professional about your specific situation.

FAQs

What is my basis when I sell a life insurance policy?

Your basis is the total premiums you have paid into the policy, not reduced by the cost of insurance, under Rev. Rul. 2020-05. Subtract any prior tax-free withdrawals or dividends taken in cash.

Do I subtract the cost of insurance from my basis?

No. That was the old Rev. Rul. 2009-13 rule, repealed by the 2017 tax law. For 2025 sales, your basis is the full premiums paid, which lowers your taxable gain.

How is the gain on a life settlement taxed?

In three layers. Proceeds up to basis are tax-free, the part up to cash surrender value is ordinary income, and anything above cash value is long-term capital gain.

Is a viatical settlement taxable?

No, generally not. Under IRC § 101(g), a sale of a policy on a terminally ill insured to a licensed viatical provider is fully excluded from federal income for 2025.

What counts as terminally ill for the tax exclusion?

A life expectancy of 24 months or less, certified by a physician. The exclusion is unlimited for terminally ill insureds, while chronically ill insureds get a capped, long-term-care-linked exclusion.

What form reports the sale to the IRS?

Form 1099-LS. The buyer files it under IRC § 6050Y to report what they paid you, and the insurer files Form 1099-SB reporting your basis and surrender value.

Where do I report a life settlement on my tax return?

On Form 8949 and Schedule D for the capital-gain layer, with any ordinary-income layer on Schedule 1 of Form 1040. The deadline is April 15, 2026, for a 2025 sale.

Is selling different from surrendering my policy?

Yes. A surrender produces only ordinary income above basis on a Form 1099-R, while a sale adds a lower-taxed capital-gain layer and usually pays more.

Do states tax the sale of a life insurance policy?

Most do. States that tax income generally tax the gain, and a few tax viatical proceeds the federal return excludes, so confirm your state’s rule before you file.

Does a policy loan affect my taxable gain?

Yes. An outstanding loan repaid at sale is treated as part of your proceeds and can create taxable “phantom” income, so settle or account for loans before selling.

Can I amend an old return that used the cost-of-insurance subtraction?

Possibly. Rev. Rul. 2020-05 applies to sales after August 25, 2009, but only open tax years can be amended — ask a CPA whether your year is still open.

What is the transfer-for-value rule?

A trap under IRC § 101(a)(2) that can make a death benefit taxable for a buyer who acquired the policy for money, unless an exception applies, such as transfers to the insured or their business.