Loss on Surrender

Today TaxMama hears from Karla in the TaxQuips Forum, with this question.  “Is the loss on surrender of life insurance deductible on 1040?”

Dear Karla,

 It’s not clear why you would have a loss when you surrender a life insurance policy. Of course, I don’t have much experience in this area.

Chapter 12 of IRS Publication 17 covers IRS rules about the net proceeds.   When the proceeds are higher than the cost, the difference is taxable.  Suppose the proceeds are lower and you have a loss?

 Well, I am certain that you may not deduct the loss on your Form 1040.  But is there a place where you may deduct the loss? Typically, losses on annuities, IRAs, etc. are deductible on Schedule A,  as a Miscellaneous Itemized deduction.

 Here is a really bizarre private letter ruling on a similar issue.  The PLR goes to great lengths to discuss the law and how to compute a loss, taking into account the fact that a portion of the premiums provided life insurance benefits, so the entire cost of the premiums is not your basis in the policy. You will have to make a computation to the reduce the basis.  It explains that there IS potentially a deductible loss. It does not explain how or where to deduct it.  

There’s a discussion in the TaxAlmanac about this, suggesting the treatment falls under IRC section 165(c)(2).  

One reply leads to an article in the Journal of Accountancy about using IRC section 165(c)(2) to take similar deductions. In which case, they suggest that the loss would not be subject to the 2% floor for miscellaneous itemized deductions. However, they warn the CPAs who are considering using this code sections “Be aware that CPAs who prepare and defend an investment loss deduction under IRC section 165(c)(2) must meet numerous technical requirements and make certain determinations based on examining the circumstances.

 So, it seems that there may be a deduction available on Schedule A, as a Miscellaneous Deduction, not subject to 2% of AGI. Before doing this, get a proper computation of the tax basis for the policy and have the treatment reviewed by someone expert in this area.

This response is PURELY an opinion and there is no assurance it is correct. It’s not an issue I’ve ever had to include in any tax return I have prepared. But I have pointed you to some resources you can use as a starting point to do the research and to find someone with experience.

 Please note: in the TaxAlmanac discussion, you find that many other tax pros have been practicing for decades without ever having to deal with this. So you are apt to find that most tax pros have no experience. Look for someone who also sells life insurance. (i.e. they are also a CFP or licensed insurance broker) They are apt to have more exposure to issues like this.

And remember, you can find answers to all kinds of questions about life insurance, and other tax issues, free. Where? Where else? At www.TaxMama.com.

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