purchasing life insurance with home equity proceeds

[joanmcq]

I have recently become aware that certain investment 'advisors' are promoting a scheme by which one takes up to $100,000 in home equity to purchase cash value life insurance. Supposedly, you get a tax deduction while having the assets grow tax free, thereby having the best of both worlds, blah, blah, blah. As you can see, I don't think much of this strategy. However, the question has been posed, is this actually possible, or does it run afoul of the Sec 264 laws against taking deductions for purchasing life insurance premiums? The only references I can find are pre 1986, and deal more with whether there was economic substance to the transaction apart from the tax benefit.

[jainen]

>>taking deductions for purchasing life insurance<<

The deduction is for interest paid on a qualified home equity loan of up to $100,000. The use of the funds is irrelevant to that deduction.

As an investment strategy life insurance has always seemed a poor bargain to me, because the yield is so low, in the 1 - 3% range. It makes no sense to pay 6% on a mortgage to get a 3% return, but if the insurance element itself is worthwile then the technique makes sense. Either way, it is legal.

[joanmcq]

Finding out more; the strategy is that the life insurance grows tax free, and then you take loans against the life insurance. When you die, the insurance pays off the loan. Sec 264(a)(3) states you cannot deduct

"any amount paid or accrued on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract (other than a single premium contract or a contract treated as a single premium contract) pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise)."

So this strategy appears to run afoul of this code section. or this section appears to contradict the rules regarding the $100,000 of equity deduction. In any case, it appears to make no sense.

[jainen]

>>So this strategy appears to run afoul of this code section<<

I think this means you can't deduct it as investment income expense if you are pulling out all the equity in that way. But qualified mortgage interest is an exception that overrides the interest rules.

There still is the problem of the low yield and the comparatively high mortgage payment. There might be some combination of details that works, but generally I can't see borrowing money to put into an investment that you immediately withdraw. Sure the policy will repay the life insurance loan, but how do you repay the mortgage loan? With the money you borrow from insurance? It doesn't make sense to me.

But then, I'm not trying to sell you life insurance!

[Burke]

Finding out more; the strategy is that the life insurance grows tax free, and then you take loans against the life insurance. When you die, the insurance pays off the loan. Sec 264(a)(3) states you cannot deduct

"any amount paid or accrued on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract (other than a single premium contract or a contract treated as a single premium contract) pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise)."

So this strategy appears to run afoul of this code section. or this section appears to contradict the rules regarding the $100,000 of equity deduction. In any case, it appears to make no sense.

I worked in the life insurance industry for 32 years. IMO, this code section is referring to the practice of using cash value within the policy (i.e, as a loan) to pay premiums on that policy (or another one.) The interest is not deductible. This can be set up automatically (called Automatic Premium Loan feature) so that it is essentially using its own cash value to pay the premiums. Of course, annual interest is charged and can eat up the cash value if not paid, terminating the contract. At the owners death or when it is cash surrendered, the proceeds are paid out and any outstanding loans are deducted and repaid to the company. It was common practice in the 1980's when bank interest rates were sky high, to borrow all the cash value at a small 5-6% guaranteed rate and invest in CD's that were paying 15-17%. This also is non-deductible personal interest. HOWEVER, in the case you state above, the home equity rules apply and the interest WOULD BE deductible under those rules, regardless what it is used for.