Policy lapse gain is the taxable income that can arise when a life insurance policy with an outstanding loan terminated by lapse or surrender and the loan is extinguished. For tax purposes, the loan payoff is treated as if the policyowner received the loan amount as a distribution. If the total of all amounts received, including the canceled loan, exceeds the policyowner's investment in the contract (total premiums paid minus prior tax-free withdrawals), the excess is taxable as ordinary income. Lapse gains are a particular concern in heavily loaned policies used for supplemental retirement income, especially when poor performance or underfunding causes the policy to collapse unexpectedly. While death benefits are usually income tax-free, a policy that lapses during life can generate significant, unplanned tax liability for the owner.

In practical planning, advisors watch for potential policy lapse gain when clients use loans to access cash value or when inforce illustrations show policies nearing exhaustion of value. They may run updated projections to see how long the policy can support planned loans and recommend premium adjustments, loan reductions, or face amount decreases to avoid collapse. Tax advisors and CPAs should be consulted when a loan-heavy policy is at risk of lapse because the taxable gain can arrive in a single year, creating a major income tax event. If a client no longer wants coverage, advisors might explore managed surrender strategies or 1035 exchanges to new policies or annuities, when appropriate, to mitigate tax consequences. Understanding policy lapse gain enables advisors to treat policy loans with respect, communicate risks clearly, and structure income strategies that balance access to cash value with long-term policy sustainability and tax efficiency.