What is a 1035 Exchange?

By

July 10 2019

One of the surest ways to build wealth is to avoid paying taxes on accumulated assets. Assets that are allowed to accumulate without the burden of taxes can grow exponentially faster than assets that are taxed. Most people are familiar with the advantages of tax-deferred vehicles, such as IRAs, 401(k) plans, annuities, in which earnings are allowed to grow without currently being taxed. It’s a huge incentive to plow as much money into them as possible.

One lesser known, but no less significant, provisions of the tax code, allow for the transfer of appreciated assets without capital gain taxes, which can substantially magnify wealth. It is section 1035 of the IRS tax code and every owner of cash value life insurance should know about them.

 

1035 Exchange Can Defer Taxes Indefinitely

 

Section 1035 provides for the tax-free exchange of “like-kind” policies. It deals with the exchange of one cash value life insurance policy, for another. Taxes on any gains generated from the policy to be exchanged are deferred and, if it is maintained throughout the lifetime of the original owner, taxes can be deferred indefinitely.

Now, that’s how serious wealth is built. If you have built up equity in a cash value life insurance policy, it would be very important and potentially very profitable to become familiar with these two provisions.

 

How Does a 1035 – Exchange of Endowments, Life Insurance, or Annuity Contracts Work?

 

Cash value life insurance is typically purchased as “permanent” insurance coverage. As long as the premium is paid, the insured is covered for life. In the meantime, a portion of the premium payment is allocated to a cash value account, which can build substantial equity over a period of time. The earnings inside a cash value account accumulate tax-free. However, if the policy is ever canceled or the cash values are withdrawn or borrowed, they are taxed as ordinary income.

It’s not uncommon for policy owners to want to change their life insurance coverage by purchasing a different policy. Maybe they find a more competitive policy with better return potential. Or, maybe the life insurer appears to be running into financial trouble. But, if they surrender their policy, the cash value earnings become taxable. However, if they exchange their policy under Section 1035, their cash value is simply transferred to the new policy which avoids any tax consequences. The IRS will treat the cash value earnings as if they were never withdrawn.

However, as with a 1031 exchange, there are a number of rules and timelines attached to a 1035 exchange which must be followed.

  • The policy can only be exchanged in the names of the current policy owner and insured.
  • If there is an outstanding loan on the policy, it must be repaid before the exchange or the policy should be reduced.
  • If the policy is to be reduced, it should be done well in advance of an exchange to avoid a “step transaction” which could nullify the exchange. Some life insurers may allow a policy loan to be transferred to the new policy and paid off after the exchange.
  • Any proceeds are taken from the original policy during the exchange may be taxed as ordinary income.

When a 1035 Exchange Might Make Sense

 

There are several reasons why someone may want to exchange their cash value life insurance policy for a new one:

  • Financial uncertainty with the current life insurer
  • New products offer better options, coverage or cash value returns
  • Can obtain a better rating due to health changes (i,e., stopped smoking, weight loss)
  • Current policy does not sufficiently address financial goals (i.e., estate planning, business continuation)

At older ages or if any health conditions arise, it’s important to maintain continuous life insurance coverage. You should never initiate a 1035 exchange unless you have been approved by the new life insurer.

 

Proceed with Caution

 

For a complicated tax code that seemingly seeks to scrape off income and limit our ability to build wealth, section 1035 offer a rare opportunity for taxpayers to build and preserve wealth. However, as with many provisions of the tax code, it is laden with tax jargon, rules, and caveats that must be understood in the context of individual circumstances. It’s always advisable to seek the guidance of a financial professional with specific expertise in the use of 1035 exchanges.

 

 

Sources:

26 U.S.C. § 1031 – U.S. Code – Unannotated Title 26. Internal Revenue Code § 1031. Exchange of property held for productive use or investment:

:https://codes.findlaw.com/us/title-26-internal-revenue-code/26-usc-sect-1031.html

26 U.S.C. § 1035 – U.S. Code – Unannotated Title 26. Internal Revenue Code § 1035. Certain exchanges of insurance policies:

https://codes.findlaw.com/us/title-26-internal-revenue-code/26-usc-sect-1035.html