If you own a permanent life insurance policy (“whole life”), you may be able to borrow against the cash value. These loans are secured by your ownership interest in the policy, so they may carry a relatively low rate of interest. What’s more, generally you aren’t required to repay these loans according to a fixed schedule. Interest that accrues without being paid is simply added to the amount of your loan balance. If you don’t pay attention, though, you can end up with an unexpected tax bill.
That’s what happened in a recent case (PDF). Over a period of years, John Sanders borrowed $7,136 against a small policy he owned. He didn’t repay the loans, and the added interest eventually caused the loan balance to exceed the cash value of the policy. He failed to respond when the insurance company demanded payment, and the life insurance policy was canceled. Bad enough that he lost the insurance policy, but he also ended up with a tax problem.
Sanders had paid over $10,000 in premiums on the policy, and he borrowed less than that amount. Yet the loan balance with all the accrued interest was over $17,000. Canceling the policy cancels the debt — and produces income measured by the $7,000 difference between the loan balance and Sanders’ basis in the policy. The IRS said he had to pay tax on this income, and the Tax Court agreed.
The amount Sanders borrowed on the policy was less than the amount he paid in premiums, but he still ended up owing $2,300 in income tax when the policy was canceled.
