Federal Tax Treatment of a Life Insurance Policy Transfer
Maria, age 65, owns a life insurance policy on her own life with a death benefit of $500,000 and a cash surrender value of $80,000. She has paid $60,000 in premiums over the years. Maria transfers the policy to her adult daughter, Elena, as a gift. At the time of transfer, the policy's fair market value is $80,000. Elena is the new owner and beneficiary. Maria files a gift tax return reporting the transfer. Two years later, Elena surrenders the policy for $90,000. Assume the transfer for value rules do not apply and the annual gift tax exclusion is $18,000.
1. What are the federal gift tax consequences of Maria's transfer of the policy to Elena?
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Maria made a gift of the life insurance policy to Elena. The value of the gift is the fair market value of the policy at the time of transfer, which is $80,000 (the cash surrender value is often used as a proxy for FMV). Since $80,000 exceeds the annual gift tax exclusion of $18,000, Maria must file a gift tax return (Form 709) and use $62,000 of her lifetime gift tax exemption. No gift tax is due if Maria has sufficient lifetime exemption remaining. The transfer is a completed gift because Maria relinquished all ownership rights.
2. What are the federal income tax consequences to Elena when she surrenders the policy for $90,000?
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Elena's basis in the policy is the greater of the donor's basis or the fair market value at the time of gift, but for life insurance policies, the basis is generally the donor's basis plus any gift tax paid. Maria's basis is $60,000 (premiums paid). Since the gift tax paid is zero (lifetime exemption used), Elena's basis is $60,000. On surrender, Elena receives $90,000, resulting in a gain of $30,000. However, for life insurance, the gain is taxed as ordinary income to the extent it exceeds basis, but the portion attributable to the cash value growth may be taxed as ordinary income. Specifically, the gain is $90,000 - $60,000 = $30,000, taxed as ordinary income. The transfer for value rules do not apply, so the death benefit would have been income tax-free, but surrender triggers income tax on the gain.