30 / Can a life insurance policy owner take an income tax deduction for the interest paid on a policy loan?

To be deductible, interest paid by a policy owner on a policy loan must meet the rules discussed below and, if applicable, the rules discussed in Q 4. However, even if the interest is deductible under those rules, the amount of the deduction may be limited depending on whether the interest is classified as personal interest, trade or business interest, investment interest, or interest taken into account in computing income or loss from passive activities. Generally, the determination is made by tracing the use to which the loan proceeds are put.¹ Thus, interest on a loan used to pay premiums on personal life insurance may come within an exception explained in Q 4, but the deduction may not be available because personal interest is not deductible. There is little guidance as to whether interest on a loan used to buy life insurance can be considered investment interest. Borrowing to finance business life insurance generally has not been considered incurred in connection with the borrower’s trade or business.

General Rule of Nondeductibility for Policy Loan Interest
(Contracts Issued After June 8, 1997)

Generally, no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer covering the life of any individual, or any endowment or annuity contracts owned by the taxpayer covering any individual.² This provision generally is effective for contracts issued after June 8, 1997, in taxable years ending after this date. For purposes of this effective date, any material increase in the death benefit or other material change in the contract will be treated as a new contract. However, in the case of a master contract, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.³

The IRS has ruled that disallowed interest under IRC Section 264(a)(4) reduces earnings and profits for the taxable year in which the interest would have been allowable as a deduction but for its disallowance under that section. It does not further reduce earnings and profits when the death benefit is received under a life insurance contract.⁴

General Rule of Nondeductibility for Policy Loan Interest
(Contracts Issued Prior to June 9, 1997)

For contracts issued prior to June 9, 1997, the general rule under IRC Section 264(a)(4) states that no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer that covered the life of any individual who is an officer or employee of, or who is financially interested in, any trade or business carried on by the taxpayer. The same rule applies to any endowment or annuity contracts owned by a taxpayer that cover any individual.⁵

Prior to legislation enacted in 1996, there was an exception to this general rule for policies with less than $50,000 of indebtedness. However, effective for interest paid or accrued after October 13, 1995, the ability to deduct policy loan interest paid on company-owned life insurance policies with loans of less than $50,000 was eliminated.⁶