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Updated July 31, 2026. Quick answer: selling a policy is taxed in three tiers (Rev. Rul. 2009-13): (1) proceeds up to your cost basis — tax-free; (2) proceeds from basis up to the cash surrender value — ordinary income; (3) everything above cash surrender value — long-term capital gain. Surrendering has only the first two tiers. The three-tier structure is why a settlement’s premium over cash value is taxed more gently than the same dollars would be inside a surrender.
Worked example
Basis $60,000, cash value $110,000, settlement price $175,000. Tier one: $60,000 tax-free. Tier two: $50,000 ordinary income (the gain a surrender would have produced). Tier three: $65,000 long-term capital gain. Versus surrendering: you’d receive $110,000 with the same $50,000 of ordinary income — the settlement adds $65,000 of price at capital-gain rates.
Two facts that changed in your favor
Basis is no longer reduced by the cost of insurance. The 2017 tax act reversed that part of the 2009 ruling retroactively (TCJA §13521; Rev. Rul. 2020-05) — basis is simply premiums paid, net of dividends taken and withdrawals, which makes tier one bigger and tier two smaller than older articles claim. And terminally or chronically ill sellers may owe nothing at all — viatical settlements for the terminally ill are generally excluded from income entirely under IRC §101(g). Compute your basis first: cost basis, done right · the decision itself: settlement vs surrender.
Three tiers, and the paperwork lands on next year’s return.
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The number that surprises people who bought a long time ago
Downsizing is the one home sale where the gain is usually large and the exclusion usually still covers it. A couple who bought in 1994 for $180,000 and sell at $760,000 with $46,000 of selling costs have a realized gain of about $534,000 before improvements. That is above the $500,000 joint cap — but decades of capital improvements are exactly what brings it back under, and most sellers have never added them up.
Improvements are the lever, and the records are the constraint
A new roof, an addition, a replaced HVAC system, new windows, a finished basement: these add to basis. Repainting and repairs do not. Thirty years of improvements on a family home routinely total six figures, and every dollar of it reduces the gain dollar for dollar. The practical problem is documentary, not legal — the seller who kept receipts pays less than the identical seller who did not.
Why downsizers should check the net investment income tax separately
A retiree with modest ordinary income can still be pushed over the 3.8 percent NIIT threshold by the sale itself, because taxable gain is net investment income. The thresholds are $250,000 on a joint return and $200,000 otherwise, written into Section 1411(b) as fixed figures with no indexing. A sale that produces $120,000 of taxable gain on top of $180,000 of other income crosses the joint threshold and picks up 3.8 percent on the part above it.
The move itself may change the tax
Downsizing usually means moving, and sometimes across a state line. Some states tax the gain the federal exclusion just removed. If the sale and the move are in the same year, the order of the two matters, and it is worth checking the destination state before signing.
Related
Methodology
- Exclusion caps, the 2-of-5 test, the nonqualified-use allocation, the reduced-exclusion fraction and the depreciation carve-out are taken from the text of 26 U.S.C. 121. The 3.8 percent rate and its thresholds are from 26 U.S.C. 1411. Both were read on 2026-07-30.
- Section 121 caps and Section 1411 thresholds are written in the statute as fixed dollar amounts with no indexing mechanism, so they are built in. Long-term capital gain brackets ARE indexed annually, so your rate is an input rather than a lookup.
- Figures were computed by two independently written engines that agree to the cent, and the calculator on this page reproduces both exactly.
- Federal only. State treatment varies and some states do not follow the federal exclusion.
Educational estimate, not tax advice, and not a filed return. Federal only. Confirm anything that changes a filing decision with a CPA or tax attorney.
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