Question: I am 65 years of age and have a $500,000 life insurance policy. Although I can afford long-term care insurance, I understand that instead of buying it, should I need a nursing home, I can sell my policy to an investor to pay for my care and not pay any income taxes. Is this correct?

Answer: Generally, if you surrender or sell an insurance policy before you die, the transaction will generate gross income equal to the difference between the proceeds received and the amount of premiums you paid less dividends paid to you. However, if you are terminally ill or chronically ill, you can sell your life insurance policy before you die and pay no income taxes based upon a federal law that became effective January 1, 1997.

These transactions -- called “viatical settlements” -- are being used by the elderly as a way to finance long-term care without purchasing long-term care insurance. Here’s how the transaction works: An investor purchases your life insurance policy for less than $500,000 by reducing the actual death benefit based on such factors as current interest rates and the probable timing of your death. The investor then becomes responsible for paying the future premiums unless your disability results in a waiver of premium.

In order exclude the proceeds of this transaction from your gross income, you must be either ``terminally ill'' or ``chronically ill.'' “Terminally ill” means that a doctor will certify that you have an illness or condition reasonably anticipated to result in your death within 24 months. “Chronically ill'' means you must have the same condition that would allow you to deduct the costs of long-term care as medical expenses. In addition, you must sell your policy to a “viatical settlement provider'' who is either licensed in your state of residence or who meets the requirements set forth in the Viatical Settlements Model Act.

Because of the potential for abuse, a number of states have enacted legislation to protect the consumer. Since viatical settlements are not securities and are not subject to SEC regulations and disclosure requirements, they are generally regulated by state agencies which have reported deceptive sales practices.

Some policies are sold with “accelerated death benefit” riders which means that the insurance company selling the policy will provide the funds rather than you putting your policy on the open market.

Taking the NextStep: Sales of life insurance policies are complex transactions that should be thoroughly reviewed for you by knowledgeable attorneys before you pass up the opportunity to purchase long-term care and rely upon a viatical settlement.