As a life settlement of an insurance policy is in effect the sale of the policy to a third-party, and not a surrender of the policy to the insurance company. Actually, the policy doesn?t need to have a cash value to be eligible for a life settlement transaction. The tax implications are twofold, and are relatively complex. While the IRS has not issued definitive guidance on life settlement transactions, it has relied on the application of its laws and regulations that address similar situations.

Basic income tax concepts clearly indicate that gains and losses are computed by taking the selling price of an item and reducing it by any selling expenses and the investment in the item. The investment in the item is known as its ?basis.? When dealing with life insurance policies, the basis in the policy is the total of all premium payments made on the contract. The amount of basis in the policy has a direct bearing on the amount of gain to be recognized from both a surrender and settlement transaction. In general, the basis computation is straight-forward, simply being the sum of the premiums paid to the insurance company.

When a surrender of a policy to the issuing insurance company occurs, the difference between the surrender proceeds and the basis in the policy is subject to income tax at ordinary income rates. This concept is important, as it is the first taxable gain computation performed in a settlement transaction. In effect, this surrender value minus basis gain is treated identically whether the policy is surrendered or settled. If the surrender value is lower than the basis, there is no ordinary gain to be reported and the proceeds are treated as a return of basis without a tax cost.

The second taxable gain computation is unique to a settlement transaction, and results in a gain that is subject to tax at favorable capital gain rates. In this computation, the settlement proceeds are compared to the surrender value used in the ordinary gain determination. Because a settlement transaction involves selling the contract, and the insurance contract is treated as a capital investment, this portion of the gain is treated as a capital gain.

To see an illustration of the above tax consequences visit Insurance Settlement Review: click here for Capital Gains Examples