34 / What are the general interest deduction rules?

As a general tax principle, interest is deductible by a cash basis taxpayer only to the extent the taxpayer actually pays it in cash or cash equivalent in the tax year.¹ Thus, if the interest due on a policy loan is not paid but is merely deducted [withdrawn] by the insurer from principal at the time of making the loan or merely added to loan principal, it is not currently deductible by a cash basis taxpayer.² Likewise, a cash basis taxpayer cannot deduct interest owing on a policy loan that is deducted by the insurer from the proceeds of a new loan with the balance being remitted to the policyholder.³ But if interest that has been deducted from or added to the principal amount of the policy loan is later paid, it is deductible by the cash basis taxpayer when paid.⁴ If the interest has been added to the loan principal, a deduction is allowable when, on maturity or surrender of the policy or on the death of the insured, the insurer deducts the accumulated interest from the proceeds.⁵

Cash basis taxpayers deduct prepaid interest over the period to which it relates, not in the year it is prepaid.⁶ An accrual basis taxpayer can deduct interest in the year it accrues, regardless of whether the interest is actually paid in that year.⁷

Only the person who owns a policy when the interest accrues is entitled to the deduction. A policy owner who takes out a policy loan and later makes an absolute assignment of the policy subject to the loan is not entitled to deduct interest that accrues after the assignment. For example, if a father continues to pay interest on policy loans after giving the policy to his children, he cannot deduct payments of interest accruing after the transfer.⁸ Nor can a husband deduct on a separate return the interest he pays on a policy loan when the policy is owned by his spouse.⁹ Similarly, a person to whom the policy has been assigned cannot pay and deduct interest that has accrued before the assignment.¹⁰

When a policyholder makes unspecified installment payments covering both premiums and interest, payments will be applied first toward premiums, and only the balance will be considered deductible interest.¹¹ Payments specified and applied as interest, however, will be treated as such.¹²

IRC Section 265(a)(2) forbids the deduction of interest on loans to purchase or carry tax-exempt investments. Borrowing to enable an insured to buy a key person policy on the insured from the insured’s employer was held sufficiently unrelated to the insured’s investment in tax-exempt bonds so that interest on the loan was deductible to the extent that the tax-exempt bonds were not used as collateral for the loan.¹³

Several cases have disallowed the deduction of interest on loans that were considered “sham” transactions – that is, transactions that offered the taxpayer nothing of economic substance other than a hoped-for deduction.¹⁴

Annual loans against cash value to pay current premiums were not considered “sham” in Coors v. U.S.,¹⁵ Lee v. U.S.,¹⁶ and Golsen v. U.S.¹⁷ The important factors in these cases were the following:

There was no prepayment of interest or premiums;

The owner needed liquidity to meet premium payments;

Death benefits were at all times substantial;

Policies were standard policies; and

The loans were straightforward, ordinary, and available to any policyholder.¹⁸

The deduction of interest on a policy loan in each of the first three policy years and the subsequent surrender of the policy in the fourth year was not considered a sham when a change in the tax law eliminated the insured’s need for the policy death benefit.¹⁹

In a case involving corporate owned life insurance policies, the Tax Court held that payments from the corporation to the insurance companies were not “interest” paid on policy loans but were, in fact, constructive dividends to the insured shareholders. The court noted that payment of these amounts by the corporation conferred an economic benefit on the shareholders by increasing both the policy cash values and the death benefits.²⁰

Deduction of interest paid on a policy loan by a grantor trust is discussed in Q 152; the deductibility of interest on a loan under a tax-sheltered annuity is discussed in Q 4068.