A Section 1035 tax-free exchange is the transaction authorized by 26 U.S.C. § 1035, which lets the owner of a life insurance policy, annuity contract, endowment contract, or qualified long-term care insurance contract swap it for a new contract without recognizing gain or loss at the time of the swap.1Cornell Law Institute. 26 U.S. Code § 1035 — Certain Exchanges of Insurance Policies The tax on any built-up gain is deferred, not erased: the old contract’s cost basis carries over to the new one, and gain is measured against that original basis when money eventually comes out.
Which Exchanges Qualify
Section 1035 works along a one-way hierarchy. Life insurance sits at the top and can be exchanged into any of the other three product types. An endowment can move to another endowment (with payments beginning no later than the original), an annuity, or a qualified long-term care policy. An annuity can move only sideways to another annuity or down to a long-term care policy. A qualified long-term care contract can be exchanged only for another qualified long-term care contract.1Cornell Law Institute. 26 U.S. Code § 1035 — Certain Exchanges of Insurance Policies
Moving in the opposite direction is not permitted. An annuity cannot be exchanged tax-free for a life insurance policy, and an endowment cannot be exchanged for life insurance. Attempting either produces a taxable event.2FindLaw. 26 U.S.C. § 1035 — Certain Exchanges of Insurance Policies3Cornell Law Institute. 26 CFR § 1.1035-1 — Certain Exchanges of Insurance Policies Section 1035 also does not cover transfers between qualified retirement accounts such as IRAs or 401(k) plans, which follow separate rollover rules.4Investopedia. Section 1035 Exchange
Rules That Make the Exchange Tax-Free
Three requirements have to be satisfied for Section 1035 treatment to apply.
The insured or annuitant must stay the same. Treasury Regulation § 1.1035-1 provides that the section “does not apply to such exchanges if the policies exchanged do not relate to the same insured.”3Cornell Law Institute. 26 CFR § 1.1035-1 — Certain Exchanges of Insurance Policies For annuities, the regulation requires the same obligee on the new contract as on the old.5Internal Revenue Service. Notice 2003-51 An individually owned annuity cannot become a joint annuity with a different owner in the exchange.
The funds have to move directly between insurers. If the policyholder takes a check from the old company and endorses it to the new one, the IRS treats the transaction as a taxable distribution rather than an exchange. Rev. Rul. 2007-24 held exactly that, applying Section 72(e) to a taxpayer who received and endorsed a check from a nonqualified annuity.6Internal Revenue Service. Rev. Rul. 2007-24
The products have to line up with the permitted hierarchy described above. Any swap outside those lanes is a taxable disposition.
What Happens to Cost Basis
The new contract inherits the old contract’s basis. Section 1035 cross-references Section 1031(d), so the new policy takes the same basis as the property given up, adjusted for any money received or gain recognized.3Cornell Law Institute. 26 CFR § 1.1035-1 — Certain Exchanges of Insurance Policies
Practically, this means the exchange defers tax rather than washing it out. Consider a $100,000 annuity that has grown to $150,000. A 1035 exchange moves the full $150,000 into a new contract, but the basis stays at $100,000. Future withdrawals or a later surrender are measured against that $100,000 figure, and the accumulated $50,000 of gain is taxed whenever it comes out of the new contract.4Investopedia. Section 1035 Exchange
Partial Exchanges
A full swap is not required. In Conway v. Commissioner, 111 T.C. 350 (1998), the Tax Court held that a direct transfer of part of an existing annuity to a new annuity with a different insurer qualified as a tax-free Section 1035 exchange because the taxpayer remained in essentially the same position, with the same funds still invested in annuities.7Internal Revenue Service. IRS Chief Counsel Memorandum 0342003
Rev. Rul. 2003-76 accepted partial exchanges and set the basis-allocation rule: the investment in the contract is split ratably between the surviving and new contracts based on the percentage of cash value transferred.8Internal Revenue Service. Rev. Rul. 2003-76
The 180-Day Safe Harbor
Rev. Proc. 2011-38, effective for transfers on or after October 24, 2011, treats a partial transfer as a tax-free exchange if no amount is received from either the original or the new contract during the 180 days after the transfer, other than annuity payments spread over ten or more years or over one or more lives.9Internal Revenue Service. Rev. Proc. 2011-38 A withdrawal from either contract inside that window risks being recharacterized as a taxable distribution.
Twenty-Four-Month Anti-Abuse Presumption
Notice 2003-51 presumes that any surrender or distribution within 24 months of a partial exchange was undertaken for tax avoidance. The taxpayer can rebut the presumption by showing the withdrawal was not contemplated at the time of the exchange, or that it followed a specific event such as reaching age 59½, death, disability, divorce, or loss of employment.5Internal Revenue Service. Notice 2003-51
Exchanges Into Qualified Long-Term Care Insurance
The Pension Protection Act of 2006 expanded Section 1035 to allow tax-free exchanges into qualified long-term care insurance contracts. Section 844 of the Act amended the code so that a life insurance policy, endowment, or nonqualified annuity could be exchanged for a qualified long-term care policy, and a long-term care policy could be exchanged for another qualified long-term care policy. The rules took effect for exchanges occurring after December 31, 2009.10Internal Revenue Service. Notice 2011-6811GovInfo. Pension Protection Act of 2006 (Public Law 109-280)
Because qualified long-term care benefits are generally received tax-free and traditional long-term care policies carry no taxable cash value, the deferred gain moved into a long-term care contract effectively disappears if the policy is later used for care.12Kitces.com. A New Way to Pay for Long-Term Care Insurance With Favorable Tax Treatment The statute also confirms that a life insurance or annuity contract does not lose its status merely because a qualified long-term care contract is attached as a rider, so hybrid products are eligible.1Cornell Law Institute. 26 U.S. Code § 1035 — Certain Exchanges of Insurance Policies
Modified Endowment Contract Status Carries Over
Under 26 U.S.C. § 7702A, a life insurance contract received in exchange for one that was already a modified endowment contract is itself a MEC.13Office of the Law Revision Counsel. 26 USC 7702A — Modified Endowment Contract Defined Industry shorthand for the rule is “once a MEC, always a MEC.” If the old policy was not a MEC, the new one avoids MEC status as long as any premiums paid in beyond the exchange proceeds stay within the adjusted seven-pay limit.14AAFMAA. 1035 Exchange MEC status matters because withdrawals and loans from a MEC are taxable on a last-in, first-out basis and can be hit with a 10 percent penalty before age 59½.
Mistakes That Turn an Exchange Taxable
- Taking possession of the funds. A check issued to the policyholder, or money that passes through a personal account, is a distribution.15Comerica. 1035 Exchange
- Changing the owner or insured. Both must stay the same across the two contracts. An individually owned contract cannot become jointly owned through the exchange.16Western & Southern Financial Group. What Is a 1035 Exchange
- Outstanding policy loans. If a loan balance on the old contract is discharged during the exchange, that discharge can create taxable income to the extent of gain in the contract.17KT&L LLP. Section 1035 Exchanges
- Exchanging in the wrong direction. Annuity to life, or endowment to life, produces immediate gain recognition.3Cornell Law Institute. 26 CFR § 1.1035-1 — Certain Exchanges of Insurance Policies
- Withdrawing too soon after a partial exchange. Money taken from either contract inside 180 days falls outside the Rev. Proc. 2011-38 safe harbor, and withdrawals within 24 months trigger the Notice 2003-51 tax-avoidance presumption.9Internal Revenue Service. Rev. Proc. 2011-38
- Assuming a 60-day rollover window. Section 1035 has none. Rollover rules for qualified plans are separate.17KT&L LLP. Section 1035 Exchanges
How the Exchange Is Reported
A Section 1035 exchange is reportable even though it is not taxable. The surrendering company issues Form 1099-R with distribution code 6, signaling a tax-free 1035 exchange.18John Hancock Annuities. 1035 Exchange Reporting If any part of the transaction is a distribution rather than an exchange, such as a discharged loan or cash boot, that portion is reported on a separate 1099-R showing the taxable amount.19Internal Revenue Service. Instructions for Forms 1099-R and 5498
Reporting is waived only when all three conditions are met: the exchange occurs within the same insurance company, it is a qualifying contract-for-contract swap with no cash distributions, and the company keeps adequate basis records.19Internal Revenue Service. Instructions for Forms 1099-R and 5498
Non-Tax Costs Worth Weighing
Section 1035 addresses income tax, and nothing else. Surrender charges on the old contract still apply, and the new contract usually starts a fresh surrender-charge schedule that restarts liquidity restrictions. A new life insurance policy resets the two-year contestability period, during which the insurer can challenge a death claim over misstatements in the application. If health has deteriorated since the original policy was issued, premiums on the replacement may be significantly higher.20FINRA. Should You Exchange Your Life Insurance Policy Older contracts sometimes carry guarantees, such as fixed growth rates or guaranteed death benefits, that will not follow the money into a new one.15Comerica. 1035 Exchange Tax deferral is real, but it is one input in the decision, not the whole answer.