Tools & Guides
Life Settlement Tax Treatment, Explained in Plain English
Every life settlement has federal tax consequences. Some sellers also face state tax depending on where they live. This guide walks through the three-tier federal framework, the 2017 TCJA changes that improved it, and the Forms 1099-LS and 1099-SB you'll see come January.
This is not tax advice and this page is not a substitute for a CPA. Tax treatment depends on your specific basis, state of residency, policy type, filing status, income level, and whether the sale qualifies as a viatical settlement. Federal and state rules also change. Consult a qualified CPA or tax attorney who understands Revenue Rulings 2009-13 and 2020-05, Section 6050Y reporting, and your state's treatment of life insurance contract sales before you sign any settlement agreement.
How Is a Life Settlement Taxed?
Federal tax on a life settlement follows a three-tier framework established by Revenue Ruling 2009-13 and updated by the Tax Cuts and Jobs Act of 2017 and Revenue Ruling 2020-05. Part of the proceeds is a tax-free return of your basis, part is taxed as ordinary income, and part is taxed at long-term capital gains rates. State tax treatment varies by state. The sections below walk through each tier, a concrete example, state-by-state differences, and the 1099 forms you will receive.
The Three-Tier Federal Framework
Under Revenue Ruling 2009-13, life settlement proceeds are split into three tiers, each taxed differently.
Tier 1: Return of basis
Up to cumulative premiums paid, net of dividends received
The portion of the settlement equal to your investment in the contract (total premiums you paid, minus any dividends you received) is a tax-free return of your own money.
Tier 2: Ordinary income
The policy's inside build-up (CSV minus basis, floored at zero)
The inside build-up is the gain you would have recognized if you had surrendered the policy instead of selling it. It's taxed at your ordinary income rate, the same rate that applies to wages and interest. If your cash surrender value is lower than your basis, there is no inside build-up to tax and Tier 2 is zero.
Tier 3: Long-term capital gains
Sale price minus Tier 1 minus Tier 2
The remaining gain is taxed at long-term capital gains rates: 0% for taxable income up to roughly $49,450 single or $98,900 married filing jointly in 2026, then 15%, then 20% at the top. A 3.8% Net Investment Income Tax under IRC § 1411 may also apply if your modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly.
A concrete example
Suppose you paid $120,000 in cumulative premiums on a whole life policy, the policy has a current CSV of $75,000, and you sell it for $250,000. The tax treatment is:
- Tier 1: $120,000 tax-free (return of basis; premiums paid).
- Tier 2: $0 ordinary income. The ordinary-income portion is limited to the policy's "inside build-up," the gain you would have recognized had you surrendered the policy. Here, the CSV ($75,000) is lower than your basis ($120,000), so there is no inside build-up to tax as ordinary income.
- Tier 3: $130,000 long-term capital gains (sale price minus Tier 1 minus Tier 2).
If your basis were lower than your CSV (for example, basis $50,000 and CSV $75,000), Tier 2 would have been $25,000 taxed as ordinary income, and Tier 3 would have been $175,000. A 3.8% NIIT may also apply on the Tier 3 amount if your income exceeds the NIIT thresholds.
The Tax Cuts and Jobs Act of 2017 Made This Better
Before the TCJA, Revenue Ruling 2009-13 required sellers to reduce their tax basis by the cumulative cost-of-insurance (COI) charges in the policy. This had the effect of increasing the taxable portion of the settlement, because less of the gross proceeds counted as return of basis.
The TCJA (Section 13521) retroactively overturned this rule for transactions entered into after August 25, 2009 (the effective date of Rev. Rul. 2009-13). Basis now equals total premiums paid with no COI reduction. This is a real upgrade for sellers: the same settlement now produces a larger tax-free tier and a smaller taxable tier than it would have under the pre-2017 rule.
Revenue Ruling 2020-05 extended the TCJA's no-COI-reduction rule to both permanent and term life policies. It modifies both Rev. Rul. 2009-13 and Rev. Rul. 2009-14 so that a seller's basis equals total premiums paid (net of dividends received), regardless of whether the contract has cash value. This resolves earlier ambiguity and confirms that term policies sold through a life settlement have a computable basis.
Tax Treatment Across the Three Exit Options
A life settlement is not the only way to exit a policy. Here's how the tax math compares across settlement, surrender, and letting a policy lapse.
| Option | Cash Received | Tax Treatment | Loss Deductible? |
|---|---|---|---|
| Life Settlement | Typically 4 to 7 times CSV (6.5x in 2024) | 3-tier framework: tax-free basis + ordinary + capital gains | Potentially, if the policy was not held for personal use (consult a CPA) |
| Surrender | CSV only | Gain above basis entirely ordinary income | Typically not deductible |
| Lapse | Nothing | May still owe if forgiven loan exceeds basis | Typically not deductible |
Note: A life settlement gain is a capital gain (long-term if the policy was held more than one year, which is effectively always). A surrender gain is entirely ordinary income. This distinction often makes the settlement path tax-advantaged even when the gross proceeds are similar.
State Taxation Varies
Federal tax treatment is the same nationwide. State tax treatment is not. A rough map:
No state tax on life settlement proceeds
Florida, Texas, Nevada, Wyoming, South Dakota, Alaska, and Tennessee have no personal income tax. A Florida or Texas seller typically pays only federal tax on the taxable portion of the settlement.
Washington: check with a WA tax pro
Washington has no general income tax but imposes a 7% excise tax on long-term capital gains above approximately $278,000 per year (2025 threshold, inflation-indexed), with a 2.9% surtax on gains above $1,000,000 for 2026. Whether a life settlement capital gain falls within the WA excise-tax base is not definitively settled by published WA Department of Revenue guidance. Large WA settlements should be reviewed by a Washington tax professional before closing.
New Hampshire
NH has no tax on wages or capital gains. Its Interest and Dividends tax is phasing out (1% for 2026, repealed beginning January 1, 2027). A life settlement capital gain is generally not classified as interest or dividends under NH law, so NH residents usually pay only federal tax on settlement proceeds.
State tax applies, generally follows the federal framework
California, New York, and most other states tax life settlement gains using something close to the federal framework. California taxes capital gains at ordinary income rates, with a top marginal rate of 12.3% plus a 1% Mental Health Services Tax on taxable income above $1 million (a combined 13.3% top marginal rate). New York State tops out at 10.9%; NYC residents add a city income tax of roughly 3% to 3.876%. Run the numbers with a local CPA.
Pennsylvania: often less favorable than federal
Pennsylvania's flat 3.07% Personal Income Tax treats a life settlement sale as a disposition of property (reported on PA Schedule D). Importantly, the PA Department of Revenue's PIT guide requires basis to be reduced by the cumulative cost of insurance, the opposite of the post-TCJA federal rule. As a result, PA sellers can face a larger taxable gain on their state return than on their federal return. A PA-licensed CPA is worth engaging before closing.
For the broader regulatory picture across all 50 states plus DC and Puerto Rico, see our state-by-state life settlement rules reference.
The Two Forms You'll Receive: 1099-LS and 1099-SB
The TCJA created two tax forms specific to life settlements, effective for sales after December 31, 2018:
Form 1099-LS
Reportable Life Insurance Sale
Filed by the buyer of your policy. Reports the sale amount paid to you and goes to both you and the IRS. You'll receive this in January or February following the year of the sale.
IRS Form 1099-LS instructionsForm 1099-SB
Seller's Investment in Life Insurance Contract
Filed by the insurance carrier under IRC § 6050Y(b). Reports the carrier's calculation of your investment in the contract (the starting point for basis) so you and the IRS have a documented number to work from. Your final basis on your tax return may include additional adjustments, for example for dividends received or MEC treatment, which a CPA will work through with you.
IRS Form 1099-SB instructionsViatical Settlements Get Special Treatment
If the insured has been diagnosed as terminally ill or as having a chronic illness, the transaction is a viatical settlement, and the proceeds may be entirely federal-income-tax-free under IRC § 101(g).
The statutory definitions are narrow:
- Terminally ill: under IRC § 101(g)(4)(A), certified by a licensed physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months.
- Chronically ill: under IRC § 7702B(c)(2), certified by a licensed health care practitioner within the preceding 12 months as either (a) unable to perform at least 2 of 6 activities of daily living (eating, toileting, transferring, bathing, dressing, continence) without substantial assistance for a period expected to last at least 90 days, or (b) requiring substantial supervision due to severe cognitive impairment. Ordinary chronic conditions like diabetes or heart disease do not by themselves meet this standard.
Two further conditions apply to the federal exclusion: the buyer must be a licensed viatical settlement provider that meets the NAIC Viatical Settlements Model Act standards (or the seller's home state's licensing requirements), and for chronically ill sellers the exclusion is limited to amounts used for qualified long-term-care expenses unless paid on a per-diem basis within the per-diem cap. A licensed viatical broker will confirm which conditions apply to your transaction.
When it does apply, the advantage is substantial. The tax-free status was enacted as part of the Health Insurance Portability and Accountability Act (HIPAA) in 1996 and remains in force. It does not eliminate state tax in every state, but at the federal level it can turn a six- or seven-figure settlement into a tax-free event for a qualifying seller.
Authoritative Sources
- Revenue Ruling 2009-13: Established the three-tier framework for life settlement proceeds.
- Revenue Ruling 2020-05: Extended the TCJA basis rule to both permanent and term life policies by modifying Rev. Rul. 2009-13 and Rev. Rul. 2009-14.
- Tax Cuts and Jobs Act of 2017, Section 13521: Retroactively eliminated the cost-of-insurance basis reduction previously required by Rev. Rul. 2009-13, effective for transactions entered into after August 25, 2009.
- Form 1099-LS Instructions (IRS) and Form 1099-SB Instructions (IRS): Official reporting forms for life settlement transactions (IRC § 6050Y).
- IRC § 101(g) and IRC § 7702B: Federal statutes governing tax-free treatment of viatical settlement proceeds and the legal definitions of terminally ill and chronically ill.
- IRS Topic No. 559 (Net Investment Income Tax) and IRC § 1411: The 3.8% NIIT that may apply to the capital-gains portion of a settlement above specific MAGI thresholds.
- IRS Topic No. 409 (Capital Gains): Current year long-term capital gains rate brackets (0%, 15%, and 20%).
- Pennsylvania PIT Guide — Net Gains from Disposition of Property: Primary authority for PA's state-level treatment of life insurance contract sales.
- Washington DOR — Capital Gains Excise Tax: Primary authority for WA's 7% long-term capital gains excise tax and the 2.9% surtax on gains above $1 million for 2026.
Life Settlement Tax FAQs
Is a life settlement taxable?
Partly. Under the federal three-tier framework established by Revenue Ruling 2009-13 and updated by the TCJA and Revenue Ruling 2020-05, proceeds up to your basis are tax-free, proceeds between basis and cash surrender value are ordinary income, and proceeds above CSV are long-term capital gains. State tax treatment varies.
What is the three-tier framework for life settlement taxation?
Tier 1 is a tax-free return of basis up to the cumulative premiums you paid (net of dividends received). Tier 2 is the policy's inside build-up (CSV minus basis, floored at zero), taxed as ordinary income. Tier 3 is any remaining gain above CSV, taxed at long-term capital gains rates (0%, 15%, or 20% federal depending on income).
Did the 2017 Tax Cuts and Jobs Act change life settlement taxation?
Yes. TCJA Section 13521 retroactively eliminated the cost-of-insurance basis reduction that Revenue Ruling 2009-13 had imposed, effective for transactions entered into after August 25, 2009. This means a seller's basis equals total premiums paid, making a larger portion of the settlement tax-free than under the pre-2017 rule.
What are Forms 1099-LS and 1099-SB?
Form 1099-LS is filed by the buyer of the policy and reports the sale amount to you and the IRS. Form 1099-SB is filed by the insurance carrier and reports the carrier's calculation of your investment in the contract (the starting point for basis). Both forms apply to sales occurring after December 31, 2018, under IRC § 6050Y.
Are viatical settlement proceeds taxable?
Under IRC § 101(g), proceeds from the sale of a life insurance policy by a terminally ill insured (life expectancy of 24 months or less) or chronically ill insured (meeting the narrow § 7702B definition) to a qualifying licensed viatical settlement provider are generally federal-income-tax-free. State tax treatment varies.
Does the 3.8% Net Investment Income Tax apply to life settlements?
The NIIT under IRC § 1411 applies 3.8% on the capital-gains portion of your settlement if your modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly. For sellers near or above those thresholds, this should be factored into the after-tax net.
Do I owe state tax on a life settlement?
It depends on where you live. Florida, Texas, Nevada, Wyoming, South Dakota, Alaska, and Tennessee have no personal income tax. Washington imposes a 7% capital gains excise tax above roughly $278,000 that may apply. New Hampshire's Interest and Dividends tax generally does not reach settlement proceeds. California, New York, and most other states tax the gain similar to the federal framework. Pennsylvania reduces basis by cost of insurance, which can make its state return less favorable than federal. Consult a local CPA.
Want to know what your specific tax picture looks like?
Start with a free estimate. We'll help you understand the potential gross proceeds, and a qualified CPA can then work out your after-tax net.