If past participants of stranger-owned life insurance were promised easy money at no cost, the rules of the game have changed. In May 2009, the IRS issued Revenue Ruling 2009-13, clarifying the taxation of life settlements. If the policyowner sells the policy to an unrelated third party, the policyowner’s basis is reduced by the value of the insurance protection. The difference between basis and the cash surrender value is taxed as ordinary income. The excess over the cash surrender value is a capital gain. This means that a policyowner has no basis in a term policy and thus the entire settlement price can be taxed as a capital gain.
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