A Hypothetical Example and Problem
A person has paid total $125,000 of premiums into a universal life policy. The policy's current cash value is $200,000.
Many years ago, the policy owner borrowed $100,000 against the policy, and after more than a decade of compounding, the loan balance has reached $200,000 cash value.
As a consequence, the policy lapses, and the insurer uses the $200,000 collateral cash value to pay off the loan.
However, because the policy was worth $200,000 at liquidation, and the cost basis was only $125,000, the policy owner will receive a Form 1099-R for $75,000, and has to pay taxes on the gain, even though no cash was received upon liquidation of the policy.
Fortunately, there are many potential solutions to rescue this life insurance policy, either to avoid the adverse tax consequence or retain the value of the death benefit itself. We will discuss in next several blog posts for the various solutions.