A non-MEC policy with $25,000 of cash value and a cost basis of $10,000 lapses while an outstanding policy loan of $18,000 is still owed. The insurer pays the owner the remaining $7,000. What amount is taxable to the policyowner?

Why D is correct

On lapse, the outstanding policy loan is treated as a distribution to the policyowner, and the total amount realized is the cash received ($7,000) plus the outstanding loan ($18,000), for a total of $25,000. Under IRC §72, the taxable gain is the total realized minus the cost basis: $25,000 − $10,000 = $15,000. The loan does not escape taxation merely because the policy lapsed; the owner recognizes gain to the extent the deemed distributions exceed the cost basis. The key is that an outstanding loan is counted as money received.

Why the other options are wrong

• A) $7,000 is only the cash actually received and ignores the $18,000 outstanding loan, which is also treated as a distribution when the policy lapses. The outstanding loan counts as received.
• B) $18,000 is the loan amount alone; the correct computation combines the $7,000 received with the $18,000 loan and subtracts the $10,000 basis. Both amounts must be combined. Then the basis comes off.
• C) $25,000 is the total amount realized before subtracting the basis; the taxable gain is the $15,000 excess over the $10,000 cost basis. Basis is always subtracted first. So $15,000 is correct.

Memory hook

Lapsed with a loan? Cash plus forgiven loan minus basis = your taxable gain.