Is a Viatical Settlement Taxable Income?

A viatical settlement allows individuals with severe health challenges to access funds from their life insurance policies while living. This financial arrangement involves selling a life insurance policy to a third party for a lump sum payment. This provides immediate cash for medical expenses, living costs, or to improve quality of life. Understanding the tax implications is important, as treatment varies based on health conditions and federal tax laws.

Understanding Viatical Settlements

A viatical settlement is a financial transaction where a policyholder with a terminal or chronic illness sells their life insurance policy to a third party. The payment received is typically less than the policy’s face value but more than its cash surrender value. The purchaser, known as a viatical settlement provider, assumes ownership of the policy, pays any future premiums, and eventually collects the full death benefit upon the insured’s passing. This arrangement provides liquidity to individuals who might otherwise be unable to access the value of their life insurance policy during their lifetime.

Taxation of Viatical Settlements

The tax treatment of viatical settlements is generally favorable under federal law, often allowing proceeds to be received tax-free. This favorable treatment stems from the IRS considering viatical settlement proceeds as an advance on the life insurance death benefit, which is typically tax-exempt. However, specific conditions must be met for tax-free status. Taxability depends on whether the insured is classified as terminally or chronically ill under IRS definitions.

An individual is considered “terminally ill” if a physician certifies that they have an illness or physical condition expected to result in death within 24 months or less from the date of certification. For terminally ill individuals, proceeds from a viatical settlement are generally tax-free. There is no limit on the amount of proceeds that can be received tax-free. This provision offers significant financial relief.

The tax rules for “chronically ill” individuals are more nuanced. An individual is considered chronically ill if a licensed health care practitioner certifies they are unable to perform at least two out of six “Activities of Daily Living” (ADLs) for at least 90 days due to a loss of functional capacity. These ADLs include eating, toileting, transferring, bathing, dressing, and continence. Alternatively, an individual may be deemed chronically ill if they require substantial supervision due to severe cognitive impairment.

For chronically ill individuals, viatical settlement proceeds are tax-free only if used for qualified long-term care services or actual unreimbursed medical expenses. If proceeds exceed actual care costs and are not used for qualified medical expenses, a portion may become taxable. The IRS sets an annual per diem limit for benefits that can be received tax-free if not specifically for actual long-term care expenses. For instance, in 2024, this daily limit was $410, and for 2025, it increased to $420 per day, or $12,775 per month. Any amount received above this per diem limit, when not substantiated by actual long-term care costs, may be considered taxable income.

An important factor in determining taxability is the adjusted basis of the life insurance policy. This basis represents total premiums paid into the policy, reduced by any previously received tax-free amounts, such as dividends or prior partial withdrawals. If a viatical settlement is taxable, proceeds up to this adjusted basis are typically tax-free. Proceeds exceeding the adjusted basis but not the policy’s cash surrender value may be taxed as ordinary income. Amounts above the cash surrender value could be treated as capital gains, though this is less common for qualifying viatical settlements.

For tax-free treatment, the viatical settlement provider must be qualified. A qualified provider regularly purchases policies from terminally or chronically ill individuals and must be licensed in the insured’s state, or meet specific rules if no state licensing is required.

Reporting Viatical Settlement Income

The viatical settlement provider must issue Form 1099-LTC, Long-Term Care and Accelerated Death Benefits. This form is provided to both the policyholder and the IRS and reports the gross benefits paid. Box 1 on Form 1099-LTC shows gross long-term care benefits, while Box 2 indicates accelerated death benefits, which include viatical settlements.

The information on Form 1099-LTC helps determine if any portion of the viatical settlement is taxable. If a portion is taxable based on health status and fund usage, it must be reported on the individual’s federal income tax return. Taxable amounts are generally reported on Schedule 1 (Form 1040), on the line designated for “Other income.”

Maintain thorough records of the viatical settlement, including Form 1099-LTC, illness certification, and how proceeds were used (especially for chronically ill individuals). These records support the reported tax treatment and are important if the IRS requests further information. Consulting with a tax professional can help ensure accurate reporting and compliance with applicable tax laws.