Life settlements are taxed in 3 ways:

• Money received from a life settlement up to the tax basis is free of income tax.
  • Money received that is greater than the tax basis, but less than the cash surrender value, is taxed as ordinary income.
  • Money received that exceeds the cash value of your policy is taxed as a capital gain.

The amount of taxable income is calculated by subtracting the total amount you have paid in premiums, your tax basis, from the life settlement amount.