The Overlooked Tax Play Hiding in an Underperforming Life Insurance Policy
Most advisors know life settlements one way. An older client no longer needs a policy, so instead of surrendering it or letting it lapse, they sell it. That is real value, and it is why settlements have earned a place in the toolkit.
But there is a second use for the same transaction that almost nobody talks about. In the right case, it matters more than the settlement check itself.
When basis is worth more than the policy
Picture a client who has carried an overfunded permanent policy for decades:
Cumulative premiums and adjusted basis: $800,000
Current cash surrender value: $300,000
Current life settlement offer: $200,000
Surrender that policy and the client generally gets nothing for the gap between what they paid in and what it is worth today. A bona fide sale is treated differently. Sell a capital asset with an $800,000 basis for $200,000 and you have realized a $600,000 loss, subject to the rules governing whether it is deductible and how it is characterized.
That difference is worth a pause before anyone signs a surrender form.
Why this is newly relevant
Before the Tax Cuts and Jobs Act, basis was reduced by the cost of insurance charges buried in the contract. TCJA changed that under IRC §1016, and Revenue Ruling 2020-05 confirmed it. The practical effect is that policies with basis sitting far above cash value are now common, and most of them are sitting quietly in client files.
Cash value is not market value
This is where people get tripped up. Cash surrender value is what the carrier owes on surrender. Fair market value is what a real buyer will pay, based on life expectancy, death benefit, ongoing premium load, policy performance, and the buyer's own return expectations. A policy with $300,000 of CSV can easily be worth $200,000 in the market, and an arm's length offer at that price is real evidence of what the contract is actually worth.
The question that decides everything
None of this creates an automatic write-off. IRC §165(c) limits what an individual can deduct, and for a policy held outside a trade or business, §165(c)(2) generally requires the loss to come from a transaction entered into for profit. High basis alone does not get there.
Which is why the client's original reason for buying matters so much. A policy purchased to protect a spouse and kids is a harder case. A policy bought and structured as a cash accumulation play, with the economics documented at the time, is a meaningfully stronger one.
What to look for
Pull the file when several of these show up together: high cumulative premium against current value, an overfunded IUL or whole life contract, an original sale built around accumulation rather than protection, performance well off the original illustration, a death benefit the client no longer needs, premiums that are no longer attractive, and ideally capital gains elsewhere that a loss could offset.
The short version of the screening question: what is this policy worth today, what is the client's adjusted basis, and could a sale create a deductible loss that vanishes the moment it is surrendered instead?
One caution
This is not a strategy to hand a client as "you have $800,000 of basis, so we will create a $600,000 loss." It requires real analysis of adjusted basis, actual fair market value, whether the sale is genuinely arm's length, whether §165(c)(2) is satisfied, and how the resulting capital loss is limited or carried forward. That work belongs with the client's CPA or tax attorney. Our job is to spot it early and get the right people looking.
If you have a client sitting on an older, high basis policy that is no longer pulling its weight, let's talk before anyone signs a surrender form. Reach out to the Watermark advanced planning team. We are happy to take a look.
This article is for informational purposes for financial professionals and is not tax or legal advice.
Deductibility of any loss depends on the client's specific facts and requires review by a qualified tax advisor.