The taxation of a viatical settlement turns almost entirely on the insured’s health status at the time of sale. If a physician has certified the insured as terminally ill, the entire payment is excluded from gross income under federal law. If the insured is certified as chronically ill, the exclusion still applies but is capped and generally tied to long-term care spending. If neither standard is met, the transaction is treated as a taxable sale of the policy, producing a mix of ordinary income and capital gain.
Full Exclusion When the Insured Is Terminally Ill
Under Section 101(g) of the Internal Revenue Code, a viatical settlement paid to a terminally ill insured is treated as though it were a death benefit under the policy. Every dollar is excluded from gross income, no matter how much it exceeds the premiums paid in.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
The tax code defines a terminally ill individual as someone whose physician has certified in writing that they have an illness or condition reasonably expected to result in death within 24 months of the certification date. That window is a hard line. A certification of 30 months does not qualify, even if the prognosis later worsens; an updated certification reflecting the shorter timeline would be needed.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
This exclusion has no dollar limit and no spending requirement. Whether the payment is $50,000 or $500,000, and whether the money goes to medical bills, a mortgage, or a vacation, the proceeds are tax-free once the physician’s certification is in hand.
Partial Exclusion When the Insured Is Chronically Ill
A chronically ill insured also qualifies for exclusion, but with a cap and conditions. There are two ways to qualify. The first is being unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) without substantial help from another person, for at least 90 days, because of a loss of functional capacity. The second is requiring substantial supervision to protect against threats to health and safety due to severe cognitive impairment.2Office of the Law Revision Counsel. 26 US Code 7702B – Treatment of Qualified Long-Term Care Insurance
Unlike terminal illness, chronic illness certification must be renewed. A licensed health care practitioner has to recertify at least once every 12 months for the exclusion to continue.3Internal Revenue Service. Instructions for Form 8853
The exclusion is capped at the IRS’s per diem limit for long-term care benefits. For the 2026 tax year, that cap is $430 per day. Payments from the settlement plus any other long-term care benefits above $430 per day count as taxable income unless actual qualified long-term care costs for those days exceeded the per diem amount.4Internal Revenue Service. Revenue Procedure 2025-32
Practically, chronically ill sellers need to keep receipts. Qualified expenses include diagnostic, preventive, therapeutic, and rehabilitative services, along with personal care and maintenance. Documented actual costs above the per diem cap remain excluded; undocumented amounts above the cap are taxable.
The Provider Licensing Requirement
The Section 101(g) exclusion applies only if the buyer is a qualified viatical settlement provider. The statute requires the buyer to be regularly engaged in the business of purchasing life insurance from terminally or chronically ill individuals, and to be licensed for that purpose in the state where the insured lives.1Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
Where a state doesn’t require licensing, the provider must instead meet the standards in the Viatical Settlements Model Act published by the National Association of Insurance Commissioners. Selling to an unlicensed buyer in a state that requires licensing disqualifies the transaction from the exclusion entirely, even for a terminally ill insured. Confirm the provider’s state licensing before signing anything.
How the Sale Is Taxed When Neither Health Standard Applies
If the insured is neither terminally nor chronically ill, the transaction is a standard life settlement rather than a viatical settlement. The full gain is taxable, and Revenue Ruling 2009-13 splits that gain across three layers based on the policy’s cash surrender value.5Internal Revenue Service. Revenue Ruling 2009-13
- Proceeds up to your adjusted basis are a tax-free return of your own premium dollars.
- The portion between your adjusted basis and the policy’s cash surrender value is ordinary income, representing tax-deferred growth inside the policy.
- Anything above the cash surrender value is a capital gain, eligible for the long-term rate if the policy was held more than a year.
A concrete example: premiums paid total $80,000 with no prior dividends or withdrawals, giving an adjusted basis of $80,000. The cash surrender value is $95,000, and the settlement provider pays $140,000. The first $80,000 is tax-free. The next $15,000 (the spread between the $95,000 surrender value and the $80,000 basis) is ordinary income. The remaining $45,000 (payment above surrender value) is capital gain.5Internal Revenue Service. Revenue Ruling 2009-13
The ordinary income layer often stings more than sellers expect. It’s taxed at the seller’s marginal rate, which can run well above the capital gains rate, and on a large settlement the layered treatment can consume a meaningful share of the payment.
Calculating Your Basis in the Policy
Basis doesn’t matter if the terminal illness exclusion applies, because the whole payment is tax-free. It matters for chronically ill sellers who exceed the per diem cap, and for anyone selling under the standard life settlement rules.
Basis is generally the total premiums paid over the life of the policy, reduced by any amounts previously received tax-free: policy dividends, withdrawals, and any outstanding loans that were never repaid. What remains is your adjusted basis.6Internal Revenue Service. For Senior Taxpayers 1
The Tax Cuts and Jobs Act changed one meaningful piece of this calculation. Sellers no longer have to reduce basis by the cumulative cost of insurance charges deducted inside the policy. Revenue Ruling 2009-13 had required that subtraction, which shrank basis and enlarged the taxable gain. That rule no longer applies to policy sales, so basis is now simply total premiums minus tax-free amounts received.
Reporting Forms You’ll See
Different forms apply depending on the transaction type and the insured’s health status. Receiving one of these forms doesn’t itself mean tax is owed; it means the transaction was reported to the IRS and needs to be accounted for on your return.
Form 1099-LTC
When a viatical settlement provider pays a terminally or chronically ill seller, the provider files Form 1099-LTC (Long-Term Care and Accelerated Death Benefits) and sends a copy to the seller. Box 2 reports the gross accelerated death benefits paid, including the viatical settlement amount. For chronically ill sellers, Box 3 indicates whether payment was made on a per diem or reimbursed basis. For terminally ill sellers, Box 3 is not checked, because the per diem cap doesn’t apply.7Internal Revenue Service. Instructions for Form 1099-LTC
Form 8853
Chronically ill sellers who receive per diem or periodic payments complete Section C of Form 8853 (Archer MSAs and Long-Term Care Insurance Contracts) with their return. That’s where the excludable amount is calculated, the $430-per-day cap for 2026 is applied, and any taxable portion is determined. Section C is also used to report accelerated death benefits received by a chronically ill insured even when no separate long-term care insurance payments were received.3Internal Revenue Service. Instructions for Form 8853
Forms 1099-LS and 1099-SB
Standard life settlements are reported under Section 6050Y. The acquirer of the policy files Form 1099-LS (Reportable Life Insurance Sale), reporting the payment amount and identifying information. The insurance company that issued the policy then files Form 1099-SB, reporting the seller’s investment in the contract (basis).8Office of the Law Revision Counsel. 26 US Code 6050Y – Returns Relating to Certain Life Insurance Contract Transactions
The taxable gain is reported on Form 1040, split between ordinary income and capital gain. Because the IRS has both the proceeds and the basis figures, the numbers on the return need to line up with what the two payors reported.
Documentation to Keep
The burden of proving eligibility for any exclusion is on the seller. At a minimum, keep:
- The physician’s written certification of terminal illness (24-month life expectancy) or the licensed health care practitioner’s certification of chronic illness, recertified annually.
- Premium payment records going back to the policy’s original issue date, which establish adjusted basis.
- Documentation of any dividends, withdrawals, or loans against the policy, since these reduce basis.
- The settlement agreement itself, along with evidence of the provider’s state licensing.
- Invoices and payment records for qualified long-term care services, if a chronically ill seller intends to claim actual costs above the per diem cap.
Missing paperwork can convert a tax-free transaction into a taxable one. The physician’s certification is the single most important document: without it, the IRS has no basis to grant the exclusion regardless of the insured’s actual condition.
Effect on Medicare Premiums
A taxable portion of settlement proceeds increases modified adjusted gross income for the year. Medicare uses MAGI from two years prior to set Income-Related Monthly Adjustment Amounts (IRMAA) for Part B and Part D premiums, so a single large taxable settlement can push a seller into a higher IRMAA bracket in a later year.
For 2026, IRMAA surcharges begin when individual MAGI exceeds $109,000, or $218,000 for married couples filing jointly, with progressively higher surcharges at each tier. Where the taxable event was a one-time occurrence and income has since dropped, a seller can ask the Social Security Administration to recalculate IRMAA by filing Form SSA-44.9Social Security Administration. Request to Lower an Income-Related Monthly Adjustment Amount (IRMAA)
Terminally ill sellers aren’t affected, because their proceeds never enter MAGI. Chronically ill sellers are affected only to the extent proceeds exceed the per diem cap or documented expenses. For standard life settlements, the entire taxable gain flows into MAGI and can trigger the surcharge.