Reasons for Using a 1035 Exchange:
To avoid current income taxation on the gain in the "old"
Generally, the surrender of an existing insurance contract is
a taxable event since the contract owner must recognize any
gain on the "old" contract as current income. However,
under IRC Section 1035 when one insurance, endowment, or annuity
contract is exchanged for another, the transfer will be nontaxable,
provided certain requirements are met. The IRS has indicated
through Private Letter Rulings that it will apply a strict interpretation
to the rules. For a transaction to qualify as a 1035 Exchange,
the "old" contract must actually be exchanged for
a "new" contract. It is not sufficient for the policyholder
to receive a check and apply the proceeds to the purchase of
a new contract. The exchange must take place between the two
To preserve the adjusted basis of the
Preserving the adjusted basis is preferable in situations in
which the "old" contract currently has a "loss"
because its adjusted basis is more than its current cash value.
The adjusted basis is essentially the total gross premiums paid
less any dividends or partial surrenders received. This basis
carryover is important when the owner has a high cost basis
in the "old" contract. For example, Jane Smith has
a Whole Life policy she purchased 15 years ago. She paid $1,000
annual premium for the last 15 years and has received $5,000
in policy dividends. The policy currently has $6,000 in cash
value. Jane's cost basis is $10,000 (15 x $1,000 less $5,000
dividends.) If Jane did not exchange the "old" policy
for the "new" one, but rather surrendered it and purchased
the "new" policy with the $6,000 surrender value,
she would only have a $6,000 basis in the "new" policy.
If, however, she exchanges the "old" policy, she will
preserve the $10,000 cost basis.
Requirements & Guidelines
The owner and insured, or annuitant, on the "new"
contract must be the same as under the "old" contract.
However, changes in ownership may occur after the exchange is
completed. The contracts involved must be life insurance, endowment,
or annuity contracts issued by a life insurance company. These
are the types of exchanges which are permitted: from an "old"
life insurance contract to a "new" life insurance
contract; from an "old" life insurance contract to
a "new" annuity; from an "old" endowment
contract to a "new" annuity contract; and from an
"old" annuity contract to a "new" annuity
contract. (Note: An "old" Annuity contract cannot
be exchanged for a "new" life insurance contract.)
Two or more "old" contracts can be
exchanged for one "new" contract. No limit is imposed
on the number of contracts that can be exchanged for one contract.
However, all contracts exchanged must be on the same insured
and have the same owner. The adjusted basis of the "new"
contract is the total adjusted basis of all contracts exchanged.
The death benefit for the "new" contract may be less
than that of the exchanged contract, provided that all other
requirements are met. Face amount decreases within the first
seven years of an exchanged may result in MEC status. When the
face amount is reduced in the first seven years, the seven-pay
test for MEC determination is recalculated based upon the lower
Under current tax law, contracts exchanged must
relate to the same insured. Any addition or removal of insureds
on the "new" contract violates a strict interpretation
of the regulations. For example, you cannot exchange a single-life
contract for a last-to-die contract or vice versa. Under certain
circumstances you may exchange a contract with an outstanding
loan for a "new" contract. This depends on the guidelines
followed by the insurance company with whom the "new"
contract is to be taken out. One possibility would be for the
loan to be canceled at the time of the exchange. If there is
a gain in the contract, cancellation of the loan on the "old"
policy is considered a distribution and may be a taxable event.
One way of avoiding this result would be to pay off the existing
loan prior to the exchange.
Exchanging a deferred annuity for an immediate
annuity qualifies for tax deferral under IRC Section 1035. However,
avoidance of the 10% will depend upon which of the IRC Section
72 exceptions the client is relying upon:
Payments made on or after the date on which
the taxpayer becomes 59½ will avoid the 10% penalty.
Payments that are part of a series of substantially equal periodic
payments made for the life expectancy of the taxpayer or the
joint life expectancies of the owner and his or her beneficiary
will also avoid the 10% penalty.
Payments made under an immediate annuity contract for less than
the life expectancy of a taxpayer who is under age 59½
probably will not avoid the 10% penalty.
IRC Section 72 requires that the immediate annuity payments
begin within one year of the purchase. The IRS will most likely
contend that the purchase date of the "new" contract
will relate back to the date of the original purchase of the
deferred annuity. Since it is unlikely the original annuity
was purchased within one year of the "new" annuity's
starting date, the payments will probably not qualify for this
Assignment to Insurer
The transfer of ownership in the old policy(ies) to the new
insurer is effected with an irrevocable assignment by the owner
to the insurer, with a designation of the insurer as both owner
and beneficiary of the old contract. The parties to the exchange
will then be: (1) the owner of the "old" contract;
(2) the insurer of the "old" contract; and (3) the
"new" insurer. The owner makes an absolute assignment
of the "old" contract to the "new" insurer
by notifying the "old" insurer, in writing. The "new"
insurer then surrenders the old policy to the "old"
insurer, and applies the proceeds of the surrender to a newly
issued contract on the same insured.
The Notice of Assignment and Change of Beneficiary
form, as well as the Notice of Intent to Surrender, should make
reference to the owner's intention to effectuate a 1035 Exchange.
The policy assigned to the "new" insurer will ordinarily
have a stated value. Therefore, the "new" insurer
receives valuable consideration upon assignment to it of the
"old" policy. For this reason, the "old"
policy should not be assigned to the "new" company
unless a favorable underwriting decision has been made and accepted
by the policyholder (this is especially important for life insurance