566 / Does the surrender of a deferred annuity contract ever result in a deductible loss?

In general, a loss deduction can be claimed only if the loss is incurred in connection with the taxpayer’s trade or business or in a transaction entered into for profit.¹ Fortunately, the purchase of a personal deferred annuity contract is typically considered a transaction entered into for profit. Consequently, if a taxpayer sustains a loss upon surrender of a deferred annuity contract, the taxpayer may claim a deduction for the loss as a loss on an investment (a transaction entered into for profit).

The amount of the loss is determined by subtracting the cash surrender value (i.e., the net proceeds received after all final charges) from the taxpayer’s “basis” for the contract. “Basis” is investment in the contract (e.g., premium paid, less any dividends received ( Q 515) and the excludable portion of any prior annuity payments). The loss is an ordinary loss, not a capital loss (which means it does not have to be and should not be netted against capital gains).²

While a deductible loss from an annuity is an ordinary loss, there has been a great deal of discussion about where a taxpayer should claim the loss on Form 1040. Some say that the loss should be treated as a miscellaneous itemized deduction that is not subject to the 2 percent-of-AGI floor on miscellaneous itemized deductions (all of which were suspended for 2018-2025 by the 2017 Tax Act and terminated under the One Big Beautiful Bill). Others take a more aggressive approach and say that the loss can be taken on the front of the Form 1040 on the line labeled “Other gains or (losses)” with supporting reporting on Form 4797.

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Planning Point: Although the IRS has not issued definitive guidance on the issue, it is notable that since 2009, IRS Publication 575 (Pension and Annuity Income) has stated the IRS position that a loss under a variable annuity is treated as a miscellaneous itemized deduction subject to the 2 percent floor (however, as noted above, these deductions were suspended for 2018-2025).³ There is no apparent reason under the IRC and existing guidance as to why such a position by the IRS would not be upheld in court, if challenged, especially since as a standard rule any deduction not explicitly allowed elsewhere under the tax code is intended to be taken as a miscellaneous itemized deduction (and there is no other place in the tax code that affords special benefits to the deduction of losses for a nonqualified annuity).⁴

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Notably, if the taxpayer purchased the contract for purely personal reasons, and not for profit, no loss deduction will be allowed. For example, in one case, the taxpayer purchased annuities on the lives of his relatives, naming his wife as the beneficiary of the contracts. Upon his wife’s death, the taxpayer obtained consent from each of his relatives (the annuitants) and named himself as the new beneficiary. He later surrendered the contracts at a loss. The court disallowed a loss deduction on the ground that, even though he suffered a loss, the contracts were not bought for profit, but rather to provide financial security for his relatives.⁵

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1.     IRC § 165.

2.     Rev. Rul. 61-201, 1961-2 CB 46; Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), aff’g 11 BTA 743 (superseded on other grounds).