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After getting more info I think I have this thing figured out. It was a single premium policy taken out in 2004, and modified to add a paid-up additions rider in 2006. The loan was subsequently made in 2008, which appears to have violated the 7-Pay Premium rule and got the thing re-classified as a MEC. That would make the loan taxable to the extent of gains. It still doesn't explain why the 1099 would mirror the interest accrual on the loan. Could just be a coincidence
They had a bad advisor if they allowed a policy to mec
If the policy loan is still outstanding when an insurance policy lapses and/or is surrendered then the amount of the loan (and interest) will be considered taxable income. If the policy has not lapsed or been surrendered the capitalized interest should either be reducing the death benefit , or increasing the loan balance (tax deferred) rather than become taxable income.