Loan offset taxation occurs when a life insurance or annuity contract with an outstanding loan is surrendered, partially surrendered, or otherwise triggers a taxable event that treats the loan balance as a distribution. The insurer effectively applies part of the policy value to repay the loan, and the amount used to offset the loan can be taxable gain to the policyowner if the policy is not a modified endowment contract and total distributions exceed basis. This can result in unexpected ordinary income, especially when heavily loaned policies lapse or are surrendered after years of borrowing without repayment.

In practice, advisors see loan offset taxation issues when clients with older, leveraged policies consider surrendering, exchanging, or letting coverage lapse. Carriers report the taxable portion of the loan offset on Form 1099-R, and clients may be surprised by large tax bills if gains have accumulated. Advisors therefore stress the importance of monitoring loan to value ratios and running in force illustrations that show how long policies can sustain loan loads. Before making changes, producers often consult with tax professionals to evaluate options such as partial repayment, 1035 exchanges into new policies or annuities, or structured surrender strategies. They also explain that in MECs and annuities, loan offsets are generally taxable to the extent of gain under LIFO rules. By understanding loan offset taxation, advisors can help clients avoid inadvertent taxable events, plan exits more strategically, and preserve long term value from policies that have been used for income or financing.