In many cases where a client is looking to replace an existing financial product with a new product, a tax-free IRC Section 1035 exchange may seem like an ideal solution—the client is able to replace the current product with a more suitable product without adverse tax consequences. Unfortunately, while this represents the best-case tax scenario, it is far from the only way that the 1035 exchange can play out. Depending upon the types of products involved and various other factors that are unique to each client's situation, the path to a 1035 exchange can be littered with tax traps that must be avoided.
Close attention must be paid to the details of the products involved, and the rules themselves, in order to avoid tax complications that can actually leave clients in a worse position than where they started.
What is a 1035 Exchange?
Generally, the Section 1035 exchange rules allow the owner of a financial product, such as a life insurance or annuity contract, to exchange one product for another without treating the transaction as a sale—no gain is recognized when the first contract is disposed of, and there is no intervening tax liability.
What Is Allowable? Knowing the Tax-Free 1035 Exchange Rules
A life insurance policy may be exchanged for another life insurance policy, an annuity or endowment contract, or a long-term care insurance policy. This can be a way out of obsolete life insurance trusts. An annuity contract may be exchanged for another annuity contract (or an annuity with long-term care benefits), but not for a life insurance policy or endowment contract. An endowment policy can be exchanged for another endowment policy that does not delay the date upon which payments will begin, or for an annuity or long-term care contract (but not for life insurance).
The owner of the policy or contract must not change in the exchange—i.e., the obligee in an annuity-for-annuity exchange must remain the same and the insured in a life-insurance-for-life-insurance exchange must remain the same. As an exception to this general rule, the IRS has allowed 1035 treatment where a change in insured individuals occurred because a policy insuring two lives in a second-to-die policy was exchanged for a single life policy after the death of one of the original insured individuals.
No tax is imposed on the gain in the original policy exchanged—and even if there is no gain in the original contract, a 1035 exchange allows the contract owner to carry over the basis of the original contract. In situations where the contract basis is higher than its cash value, the higher basis (which can eventually be withdrawn tax-free) will be preserved.
What Are the Tax Traps and Pitfalls of 1035 Exchanges?
Despite the potentially favorable tax treatment, clients should exercise caution when entering into a 1035 exchange. Any cash received, amounts transferred into a non-qualifying contract or amounts used to extinguish an outstanding loan on the original contract will be taxed at the client's ordinary income tax rate.
Even if the client first takes a distribution from the original contract and then completes the exchange, there is a possibility that the IRS will treat these events as a single transaction under the "step transaction" rules.
Further, the rules become more complicated when an outstanding loan on the original contract exists. In order to avoid recognizing gain, a policy loan generally must be carried forward to the new contract in the same amount. Unfortunately, many insurance carriers may be unwilling to issue a new life insurance policy with an outstanding loan and, if this is the case, the client may be required to pay back the loan before the exchange can take place.
