37 / How is gain on the surrender of a cash value life insurance policy calculated after 2008?

Editor’s Note: The 2017 tax reform legislation reversed the IRS position in Revenue Ruling 2009-13, and instead now provides that in determining basis, no adjustment is made for mortality, expense or other reasonable charges incurred under the contract (the “cost of insurance”) in the case of a policy sale. Therefore, on sale of a cash value insurance policy, the insured’s basis is no longer reduced by the cost of insurance.¹ This new rule for determining basis is effective retroactively, to transactions entered into after August 25, 2009.²

Revenue Ruling 2009-13 explains how to calculate the amount and character of gain upon the surrender or sale of a life insurance policy by the insured.³ The example below illustrates the results upon surrender of a cash value policy (Situation 1). For examples illustrating the treatment of the sale of a cash value life insurance policy and the sale of a term life insurance policy, see Q 38 and Q 39.

Revenue Ruling 2009-13: Situation 1

Facts: On January 1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John’s family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John surrendered the policy on June 15, 2008, for its $78,000 cash surrender value, including a $10,000 reduction for the cost of insurance protection provided by the insurer (for the period ending on or before June 15, 2008). Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy’s cash surrender value. John was not terminally or chronically ill on the surrender date.