568 / What are the income tax consequences to the owner of an annuity contract if the owner sells the contract?
However, the tax treatment of a sale of a deferred annuity for more than the annuity surrender value is not entirely clear. For example, assume an annuity with a $50,000 cost basis and a $75,000 surrender value was sold for $85,000 (perhaps because it provides a contractual interest rate guarantee that is more appealing than current market rates). The $25,000 gain from cost basis to surrender value must be taxed as ordinary income. It is not clear, however, whether the additional $10,000 of gain would be taxed as though it were an “amount not received as an annuity” (i.e., ordinary income treatment), or the sale of the entire annuity contract as though it were a capital asset (i.e., capital gain treatment). Similar favorable treatment has been allowed in the case of the sale of a life insurance policy for more than its cash surrender value.2
Where an annuity contract is sold after maturity, the cost basis of the contract (for purpose of computing the seller’s gain) must be reduced by the aggregate excludable portions of the annuity payments that have been received. The adjusted cost basis, however, cannot be reduced below zero (for example, where the annuitant has outlived his or her life expectancy and was able to exclude amounts in excess of his or her net premium cost).3 The taxable gain, that is, cannot be greater than the sale price. Where an annuity contract is sold for less than its cost basis, the seller realizes an ordinary loss ( Q 566).
If the contract sold is subject to a nonrecourse loan, the transferor’s obligation under the loan is discharged and the amount of the loan is considered an amount received on the transfer.4
1. First Nat’l Bank of Kansas City v. Commissioner, 309 F.2d 587 (8th Cir. 1962); Roff v. Commissioner, 304 F.2d 450 (3d Cir. 1962).