What is a 1035 Exchange?

What is a 1035 exchange?

Disclaimer: This post will describe what a 1035 exchange is as we have learned it in the field by performing hundreds of exchanges. Tax laws constantly change, this will give you a general idea of what a 1035 exchange is and that is all it is designed to do. Please check with your company or tax professional to confirm any of this information.

A 1035 exchange as it is known in the insurance industry is IRS tax code that allows for money to be moved from like life insurance policies to to other like life insurance policies or from like life insurance policies to like annuities under tax code number 1035. By like policies I am referring to the fact that the life policies that participate in the exchange must be similar. For example, you cannot move money from a survivor or second to die life policy to a single life policy or vice versa. (Same goes for single life annuities and joint annuities.) You cannot exchange money from an annuity to a life insurance policy. You can however move money under this code from a life to annuity policy, and you can also exchange value from annuity to annuity. Also, the Pension Protection Act , which was revised January of 2010 allows for exchange from current annuities and life policies to new annuities and life policies with long term care payout benefits.
A 1035 exchange is useful to avoid a taxable event in surrendering or exchanging insurance contracts. If you have growth in your life insurance or annuity policy, meaning more money than your "basis" or what you have paid in, then the growth of that policy is considered a taxable distribution if taken via surrender or withdrawal. This tax can be avoided if a 1035 exchange is properly executed.

Ok, I hope that is clear and I tried to put it in layman's term as best I could. Below,  I will post verbatim the tax code from the IRS. If you have any questions contact me and I will be glad to answer any questions.

    Sec. 1035. Certain exchanges of insurance policies
 
    (a) General rules
      No gain or loss shall be recognized on the exchange of -
        (1) a contract of life insurance for another contract of life
      insurance or for an endowment or annuity contract or for a 
      qualified long-term care insurance contract;
        (2) a contract of endowment insurance (A) for another contract
      of endowment insurance which provides for regular payments
      beginning at a date not later than the date payments would have
      begun under the contract exchanged, or (B) for an annuity
      contract, or (C) for a qualified long-term care insurance contract;
        (3) an annuity contract for an annuity contract or for a
      qualified long-term care insurance contract; or
        (4) a qualified long-term care insurance contract for a 
      qualified long-term care insurance contract.
    (b) Definitions
      For the purpose of this section -
      (1) Endowment contract
        A contract of endowment insurance is a contract with an
      insurance company which depends in part on the life expectancy of
      the insured, but which may be payable in full in a single payment
      during his life.
      (2) Annuity contract
        An annuity contract is a contract to which paragraph (1)
      applies but which may be payable during the life of the annuitant
      only in installments. For purposes of the preceding sentence, a 
      contract shall not fail to be treated as an annuity contract 
      solely because a qualified long-term care insurance contract 
      is a part of or a rider on such contract.
      (3) Life insurance contract
        A contract of life insurance is a contract to which paragraph
      (1) applies but which is not ordinarily payable in full during
      the life of the insured. For purposes of the preceding sentence, 
      a contract shall not fail to be treated as a life insurance 
      contract solely because a qualified long-term care insurance 
      contract is a part of or a rider on such contract.
    (c) Exchanges involving foreign persons
      To the extent provided in regulations, subsection (a) shall not
    apply to any exchange having the effect of transferring property to
    any person other than a United States person.
    (d) Cross references
          (1) For rules relating to recognition of gain or loss where
        an exchange is not solely in kind, see subsections (b) and (c)
        of section 1031.
          (2) For rules relating to the basis of property acquired in
        an exchange described in subsection (a), see subsection (d) of
        section 1031.