Life insurance to pay off debt

Dear Tax Talk,
I sold a piece of property on the installment sale method and the buyer has been making payments for years. In the sales agreement, the buyer was required to have insurance that would pay off the loan if she died. She died recently, and I am the beneficiary of a life insurance policy that almost pays off the debt. Will the life insurance be taxable as if I received a payment on the loan?
–Carolyn

Dear Carolyn,
Every once in a while I get a question out of the ordinary that makes me pull all the books off the shelves. Well, we don’t actually use books anymore, but certainly we do a lot of Web surfing.

You probably ask the question because you know that the general rule is that life insurance is tax-free to the recipient. An exception to this rule is a transfer of a life insurance contract for valuable consideration. Because the policy was issued in your name as beneficiary for the transfer of the land, this rule would come into play.

When you report the sale of property under the installment sales rules, a portion of every payment is applied to your original cost in the sold asset, and part to gain on the property. This is done based on your gross profit percentage. The collection of the life insurance proceeds would be considered just as any other collection on the loan you had against the property. Assuming you receive the remaining balance of the loan that was not paid off through insurance, your gross profit is the same and your gain is the same as if you had just been paid otherwise.

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