Is the Surrender of an Annuity with Losses Deductible?

These economic times have resulted in losses not only in the real estate and stock markets but in annuity contracts.  Many individuals holding annuity contracts may wish to surrender or sell the annuity and take a deduction against the loss.  Is this possible?

A deduction for the loss in an annuity can be claimed only if the loss is incurred in connection with the taxpayer’s trade or business or any transaction entered into for profit.  Under most circumstances, the purchase of a personal annuity is considered a transaction entered into for profit.  Therefore, a taxpayer who sustains a loss upon the surrender of a refund annuity may claim a deduction for that loss, no matter whether he purchased the contact in connection with his trade or business or as a personal investment.

The extent of the loss will be determined by subtracting the cash surrender value from the taxpayer’s “basis” for the contract.  The basis is determined by taking the gross premium less all amounts previously received tax free under the contract, for example, any excludable dividends, and the excludable portion of any prior annuity payments.

The loss is considered an ordinary loss, not a capital loss.  However, if the taxpayer purchased the annuity purely for personal reasons and not for profit, then the loss deduction will not be allowed.  As an example, if the taxpayer purchased annuities on the lives of his relatives, and then gave the relatives ownership of the contracts, and at a later time acquired the contracts by gift and then surrendered them at a loss, this would have been considered a personal purpose since the annuities were actually bought not for profit but instead to provide financial security for the relatives.

As to where the loss should be taken on the 1040, this is subject to much discussion.  Some advisors prefer to take the loss as a miscellaneous itemized deduction not subject to the 2% floor.  On the other hand, others say it is a miscellaneous itemized deduction subject to the 2% floor.  Finally, others take a more aggressive approach in stating the loss can be taken on the front of the 1040, on the line labeled “Other Gains (or Losses)”.

In the 2007 edition of the IRS publication 575, Pension and Annuity Income, the IRS states that a loss under a variable annuity will be treated as a miscellaneous itemized deduction subject to the 2% floor.  As always, it is important to work closely with your advisors when determining what losses should be taken.