1035 Exchange

A 1035 exchange is the exchange of one insurance or annuity contract for another under section 1035 of the Internal Revenue Code, on which no gain or loss is recognized at the time of the exchange. The section is headed "Certain exchanges of insurance policies", and the number is doing the naming work here because the statute supplies no noun phrase of its own. It is the insurance cousin of the like-kind exchange rule for real property, and section 1035 borrows that rule's machinery outright: subsection (d) cross-references section 1031 for both the treatment of anything else received in the deal and the basis of what comes out.

The point of the provision is narrow and worth stating plainly. It defers tax on a switch between contracts; it does not forgive it. A policyholder who has a gain inside an annuity and wants a different annuity can move without settling up first, and the gain travels with them. Nothing about the exchange makes the new contract better, cheaper or more suitable, which is why the tax treatment is the least interesting part of most exchange decisions and the part most often used to open the conversation.

The permitted directions, as the statute lists them. Section 1035(a) allows the exchange of a contract of life insurance for another life insurance contract, or for an endowment or annuity contract, or for a qualified long-term care insurance contract; a contract of endowment insurance for another endowment contract whose regular payments begin no later than they would have under the old one, or for an annuity contract, or for a qualified long-term care contract; an annuity contract for another annuity contract or for a qualified long-term care contract; and a qualified long-term care contract for another qualified long-term care contract. Set out that way the structure is visible, and it reads more usefully as two rules about arrivals and departures than as a list. Nothing but a life insurance contract can be exchanged into life insurance, so an annuity or an endowment cannot be turned into coverage on a life. And nothing can come out of a qualified long-term care contract except another qualified long-term care contract, so value moved there stays in that form. The regulation states the first restriction outright rather than leaving it to be inferred. Treasury Regulation section 1.1035-1 provides that section 1035 does not apply "to transactions involving the exchange of an endowment contract or annuity contract for a life insurance contract, nor an annuity contract for an endowment contract", and that "[i]n the case of such exchanges, any gain or loss shall be recognized." The regulation predates the 2006 amendment that added qualified long-term care contracts, so the statute is the place to read that limb.

Two identity conditions travel with the transaction. The regulation limits a tax-free annuity-for-annuity exchange to cases where the same person or persons are the obligee under the new contract as under the old one, and requires the policies exchanged to relate to the same insured. In practice this is where attempted exchanges fail: changing the owner, the annuitant or the insured in the same motion is not an exchange of one contract for a comparable one, it is a disposition.

Basis carries over, which is the fact that makes the whole thing coherent. Section 1035(d)(2) sends the basis question to section 1031(d), under which the basis of the new property "shall be the same as that of the property exchanged", adjusted for money received and gain recognized. So the new contract inherits the old contract's investment in the contract rather than being treated as bought for the amount transferred. Two consequences follow that people consistently get backwards. A gain does not vanish: it sits inside the new contract waiting for a future withdrawal, surrender or annuitization. And a loss position survives too, which is the underrated half. Where a contract is worth less than its investment, exchanging preserves the higher basis, while surrendering for cash generally realizes nothing deductible on a personal life policy.

Boot is where the tax bill actually comes from. Section 1035(d)(1) cross-references section 1031(b) and (c). Under 1031(b), where an otherwise qualifying exchange includes "other property or money", gain is recognized "but in an amount not in excess of the sum of such money and the fair market value of such other property"; under 1031(c), a loss is still not recognized. Cash taken out at the exchange is the obvious case. The less obvious and far more common one involves a policy loan. The IRS's own instructions for Forms 1099-R and 5498, in the paragraph describing section 1035 exchanges, state that "the distribution of other property or the cancellation of a contract loan at the time of the exchange may be taxable and reportable on a separate Form 1099-R." So an owner who exchanges a loaned policy and lets the old insurer clear the loan out of the value, rather than carrying the debt across to the new contract, has generally received that amount. On a life insurance or annuity contract the resulting income is ordinary.

A partial exchange of an annuity is possible and carries a waiting period. Revenue Procedure 2011-38, which modified and superseded Revenue Procedure 2008-24, treats a direct transfer of part of one annuity contract into another as a tax-free exchange provided no amount, other than an amount received as an annuity for a period of ten years or more or over one or more lives, is received under either contract during the 180 days beginning on the date of the transfer. A withdrawal inside that window puts the characterization of the whole transaction back on general tax principles and the facts. The procedure also states that the Service will not require the pre-existing contract and the new one to be aggregated, even where the same insurance company issued both.

What an exchange does not do. It does not waive a surrender charge still running on the old contract, and the replacement generally starts a fresh surrender schedule of its own, so a contract three years from the end of its charge period can come out of an exchange with another seven or ten years to run. Sales compensation is payable on the new contract, which is why the exchange decision and the product decision are worth separating: the honest question is whether the replacement contract is better on its own terms, and the tax deferral is a condition rather than a reason.

1. Check the direction. Confirm the exchange is one of the four paragraphs of section 1035(a). An annuity or endowment contract exchanged for life insurance is a taxable disposition, not an exchange.

2. Keep the parties the same. The obligee and the insured must carry across.

3. Move the value directly. The old insurer transfers to the new one. Taking a check and reinvesting it is a surrender followed by a purchase.

4. Decide what happens to any policy loan before the paperwork is signed. Carrying the debt to the new contract and clearing it out of the old value are different transactions with different tax results.

5. Basis carries over to the new contract under section 1031(d), adjusted down for money received and up for gain recognized.

6. The new contract's own charges start over, including any surrender schedule.

A hypothetical, showing the clean case and then the boot. Priya's deferred annuity is worth $120,000 and her investment in the contract is $70,000, so there is $50,000 of gain inside it. She exchanges it for another annuity and takes nothing out. No gain is recognized, and the new contract's basis is $70,000, so the $50,000 is still there, waiting.

Now change one fact: at the exchange she also takes $8,000 in cash. Under section 1031(b) the gain recognized is limited to the money received, so $8,000 is ordinary income this year, not the whole $50,000. Her basis in the new contract is $70,000 − $8,000 of money received + $8,000 of gain recognized = $70,000, unchanged. The new contract is worth $112,000 against that $70,000 basis, so $42,000 of gain remains inside it, which is the original $50,000 less the $8,000 already taxed. Taking boot did not reduce her basis; it moved $8,000 of tax forward.

A second hypothetical, on the loan. Wendell exchanges a cash-value life policy with a cash surrender value of $95,000, an outstanding policy loan of $20,000, and an investment in the contract of $60,000. The old insurer clears the loan out of the value and transfers the remaining $75,000 to the new insurer. He has received the new contract worth $75,000 plus the discharge of $20,000, so the realized gain is $95,000 − $60,000 = $35,000 and the boot is $20,000. Gain is recognized up to the boot, so $20,000 is ordinary income. His basis in the new contract is $60,000 − $20,000 + $20,000 = $60,000, and the $15,000 of remaining gain sits inside a contract worth $75,000. Nothing about the exchange was defective. He simply took $20,000 out of the transaction without noticing, because it left as a loan repayment rather than as a check.

Pros

• The gain is not taxed at the time of the move, so a contract can be replaced without a tax bill standing in the way of a better one.
• Basis carries over rather than resetting, so a contract standing at a loss keeps its higher basis instead of realizing nothing.
• The route into a qualified long-term care contract is open from life insurance, endowment and annuity contracts, which can repurpose a policy whose original purpose has gone.
• A partial exchange of an annuity is available on stated conditions, so the whole contract need not be moved.
• The mechanics are administrative: the insurers transfer the value directly and report what needs reporting.

Cons

• The permitted directions are one-way, and an exchange attempted in the wrong direction is a fully taxable disposition rather than a failed exchange.
• A discharged policy loan is generally an amount received, which produces ordinary income out of a transaction the owner thought was tax-free.
• The replacement contract usually starts a new surrender charge schedule, so liquidity can move backwards even when costs improve.
• Nothing about the tax treatment says the new contract is better, and the provision is a standing feature of how replacement contracts are presented.
• Changing the owner, annuitant or insured in the same step can disqualify the exchange entirely.
• Deferral is not forgiveness. The gain is still there, and it is ordinary income when it finally comes out.