If I surrender a life insurance policy at a loss, may I deduct the loss? If so, is it an ordinary or capital loss?
Most of the litigation on this issue occurred in the 1930s and 1940s, and there has been little since then. The weight of legal authority leans against deducting a loss on surrender of a life insurance policy. The primary reasons are:
- The transaction (purchase of the policy) was not entered into with the intent to make a profit.
- The loss is not deductible because the policy contains two features – insurance protection and investment – and “[t]here was no separation of the premiums … as one part paid for protection only and the balance as a reserve investment.” London Shoe Co. v. Commissioner, 80 F.2d 230 (3rd Cir, 1935).
- Genworth Financial opined recently (without offering any judicial support) that the loss is non-deductible because it is a personal rather than business or investment asset. Losses on personal assets such as houses are not deductible, although losses on personal investments are deductible.
But, in a case where separation of the amounts paid for insurance protection and for investment was possible, a capital loss was allowed on surrender of the policy. Cohen v. Commissioner, 44 BTA 709 (1941). See the relevant text from the case below.
I think Cohen provides good precedent. There is support for calculating the loss on the investment portion. The insurance protection portion of the policy may be computed by totaling the term life premiums that would have been charged on a term-only policy. For example, say that the premiums paid on the life insurance policy total about $346K. Assuming the term premiums that would have been paid since inception in 2002 would have been $60K, the adjusted cost basis of the investment portion of the policy would be about $286K. Subtracting the adjusted cost basis from the $239K cash surrender value yields a $47K capital loss. Also, I believe there is an intent to profit on the investment portion. Hence, I would deduct the loss on the investment portion.
MOSES COHEN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT, 44 B.T.A. 709 (1941): “Therefore, in the instant proceeding we do not think we should overlook or fail to take into account the dual factors of investment and insurance protection which are inherent in the policies here involved. That portion of the premiums paid for mere insurance protection is of course a personal expense and as such is not deductible. Sec. 24(a)(1), Revenue Act of 1936. That portion of the premiums paid by reason of the investment feature of the contract is a capital expenditure and as such is not deductible. Sec. 24(a)(2). Petitioner is not contending for the deduction of any of the premiums paid. He contends that he lost a part of his capital investment, namely, $3,556.86 of the cash surrender value of the policies, and that such loss is deductible under section 23(e)(2), supra. For reasons above stated, we sustain this contention.” (Emphasis added.)