Is Interest Paid on a Life Insurance Loan Tax Deductible?

Borrowing against a life insurance policy provides liquidity without the rigid repayment terms of traditional loans. Many policyholders wonder whether the interest on these loans is tax deductible, which could enhance their financial strategy. The answer depends on how the borrowed funds are used and whether they meet IRS requirements. Understanding these rules is crucial before assuming any tax benefits.

Basic Criteria Under Tax Regulations

The IRS does not allow interest deductions on all loans, including life insurance policy loans, unless specific conditions are met. Internal Revenue Code (IRC) Section 163 governs deductible interest expenses, distinguishing between personal, investment, and business-related interest.

Personal interest, such as credit card or car loan interest, is generally non-deductible. However, interest on loans used for investment or business purposes may qualify. IRC Section 264 further restricts deductions on loans secured by life insurance policies, particularly for personal expenses. This prevents taxpayers from using life insurance as a tax shelter while benefiting from policy loans.

The amount borrowed and the policy’s cash value can also impact deductibility. Large loans may draw IRS scrutiny to ensure compliance with deductible interest rules. Additionally, if the policy is classified as a modified endowment contract (MEC), stricter tax rules apply. MECs fail the “7-pay test,” which determines if a policy has been overfunded relative to its death benefit.

Classification of Loans for Deductibility

The IRS categorizes interest deductibility based on how the borrowed funds are used. Loans for personal expenses, such as vacations or home renovations, do not qualify. However, loans used for investment purposes—such as acquiring taxable securities or funding a rental property—may be deductible under investment interest expense rules.

Investment interest expense is deductible up to the amount of net investment income, which includes taxable interest, dividends, and other investment returns. If the loan funds are used to buy stocks or bonds that generate taxable income, the interest may qualify for deduction. However, if the investment produces tax-exempt income, such as municipal bonds, the deduction is disallowed.

Loans used for passive income activities, such as real estate partnerships or businesses where the borrower does not actively participate, are subject to passive activity loss rules. These rules limit the deduction of interest against active income, potentially deferring the deduction if there is insufficient passive income. This is particularly relevant for policyholders using life insurance loans to fund limited partnership interests or rental properties managed by third parties.

The Role of Business Purposes

Using a life insurance loan for business expenses may allow for interest deductions if the borrower can demonstrate a direct connection between the loan and business operations. If the loan funds are used for purchasing equipment, covering payroll, or expanding operations, the interest may be deductible under IRC Section 162, which covers ordinary and necessary business expenses.

The business structure also affects deductibility. Sole proprietors who use policy loan proceeds for business purposes can typically claim the interest as a Schedule C deduction. For partnerships, S corporations, or C corporations, the deduction depends on how the loan is structured and whether the business is responsible for repayment. If a business entity borrows against a policy it owns and uses the loan for operational expenses, the interest may be deductible at the corporate level. However, if an individual borrows personally and then lends the funds to their business, the IRS may not consider the interest a legitimate business expense.

There are restrictions when life insurance policies serve as collateral for business loans. IRC Section 264(a)(4) limits interest deductions unless the policy covers key employees or is required for a financing agreement. Some businesses structure loans to avoid these restrictions by ensuring the policy is not directly tied to the loan. For example, a company may secure a line of credit for working capital and use a life insurance policy as a general asset rather than direct collateral, preserving the deductibility of interest payments.

Documentation for Interest Deductions

Proper documentation is essential when claiming an interest deduction on a life insurance loan. The IRS requires proof of both the loan’s purpose and the corresponding interest payments. Without proper records, deductions may be disallowed in an audit, leading to penalties and interest assessments.

Taxpayers should maintain a loan agreement outlining the borrowing terms, including the interest rate, repayment schedule, and collateral arrangements. Keeping a separate account for borrowed funds can clarify how the money was used, particularly if allocated toward deductible expenses.

Interest payments should be documented through financial statements, bank records, and policy statements showing accrued and paid interest amounts. Retaining cancelled checks, electronic payment receipts, or lender-provided interest statements is essential for verification. If the loan was used for investment purposes, brokerage statements and investment purchase records should be kept to demonstrate compliance with IRS rules.

Considerations for Policy Ownership

The ownership structure of a life insurance policy affects whether interest on a policy loan is deductible. Tax treatment varies depending on whether the policy is held by an individual, a business, or a trust.

For business-owned policies, deductibility depends on how the policy is used. If a corporation takes out a policy on a key employee and later borrows against it for business expenses, the interest may be deductible under certain conditions. However, if the policy is primarily for executive compensation or shareholder benefit, deductions may be limited under IRC Section 264. Businesses must also consider employer-owned life insurance (EOLI) rules, which require specific notice and consent procedures to avoid adverse tax consequences.

For policies held in a trust, such as an irrevocable life insurance trust (ILIT), interest deductibility becomes more complex. Trust-owned policies are often used for estate planning, and loans taken against them may not qualify for deductions unless they serve a business or investment purpose. Trustees must carefully document the purpose of any borrowing to ensure compliance with IRS regulations.