1035 Exchange Life Insurance: How to Swap Policies Without a Tax Bill

A 1035 exchange life insurance transaction lets you swap an existing life insurance policy for a new one without paying income tax on the gain inside the old policy. The rule comes from Section 1035 of the Internal Revenue Code. It is most useful when an old policy no longer fits, such as a universal life policy at risk of lapsing. This guide covers what the law allows, what it doesn’t, how loans can create a tax bill, surrender charges, and the Massachusetts replacement rules.

This page is general information, not tax or legal advice. Before any exchange, get an in-force illustration of your current policy and ask a tax professional to review the numbers.

What is a 1035 exchange life insurance swap?

If you surrender a policy for cash, IRS Publication 525 says you must include in income any proceeds above your cost, which is generally the premiums you paid minus certain amounts you already received tax-free. A 1035 exchange avoids that. Under IRC §1035(a), “no gain or loss shall be recognized” on certain exchanges of insurance contracts.

In a 1035 exchange life insurance swap, the old insurer transfers the policy’s value directly to the new insurer, which issues a new contract. You never take the cash. Your cost basis carries over to the new policy under the cross-reference to §1031(d) in the regulations, so the gain is deferred, not erased.

Three conditions matter most in any 1035 exchange life insurance transaction:

• The right kind of contracts, as listed in the statute (see the table below).
• The same insured. Treasury Regulation §1.1035-1 says the exchange doesn’t qualify if the policies don’t relate to the same insured.
• A direct exchange. Cash you receive along the way, or other property, is taxed under the boot rules covered below.

Which exchanges are tax-free?

Section 1035(a) lists the permitted exchanges. Read it carefully: for 1035 exchange life insurance moves, it works in one direction.

The last row is the one people miss. The regulation says §1035 does not cover exchanging an endowment or annuity contract for a life insurance contract, and for those, “any gain or loss shall be recognized.” Once you move life insurance value into an annuity, you can’t use §1035 to move it back into life insurance.

The long-term care options were added by a 2006 law and apply to exchanges after December 31, 2009, according to the statute’s notes. The statute also says a long-term care rider on a life or annuity contract doesn’t disqualify it.

Life-to-life: how to replace an old universal life policy

The most common reason to use a 1035 exchange life insurance swap is to replace an old universal life policy that is no longer on track. Universal life has flexible premiums, and the policy stays in force only while its value can cover its monthly charges. If your annual statement shows the value shrinking, the policy may be headed for a lapse.

Before you replace an old universal life policy, ask the current insurer for an in-force illustration at your current premium and at a higher premium. Sometimes paying more keeps it in force more cheaply than replacing it. If not, an exchange can move the remaining value into a new policy, often a guaranteed universal life or whole life contract with stronger guarantees.

A life-to-life exchange only works if you qualify for the new policy. The new insurer will underwrite you based on your current age and health. If your health has changed, the new premium can be much higher, or the application can be declined. Never surrender or stop paying the old policy until the new one is issued and in force.

Questions to ask before you replace an old universal life policy:

• At my current premium, in what year does the illustration show the policy ending?
• What premium would keep it in force to age 100 or beyond, on guaranteed assumptions?
• Is there a surrender charge today, and when does it end?
• Is there a loan, and how would the new insurer handle it?
• Does the old policy have riders or guarantees the new one won’t?

Bring those answers to any 1035 exchange life insurance discussion. They turn a sales conversation into a comparison.

Other life-to-life reasons include:

• Moving from a policy with high internal charges to one with lower costs.
• Adding features the old policy lacks, such as living benefits riders.
• Combining a small cash value into a new policy designed for a different goal.

1035 exchange life insurance to annuity

A 1035 exchange life insurance to annuity transaction is allowed by §1035(a)(1). People consider it when they no longer need the death benefit but want to keep the cash value growing tax-deferred, or turn it into income.

Points to weigh before a 1035 exchange life insurance to annuity move:

• The death benefit ends. An annuity is not life insurance. If anyone still depends on the payout, this move removes it.
• It is one-way. As shown above, annuity-to-life exchanges aren’t tax-free.
• Annuity surrender charges. FINRA’s investor guide Should You Exchange Your Variable Annuity? warns that surrender charges can be very expensive if you withdraw early, and that a new contract may come with a longer surrender period.
• Taxes when you withdraw. The gain is deferred, not forgiven. It is taxed when you take money out of the annuity.

Annuity-to-annuity partial exchanges have their own IRS guidance. Rev. Proc. 2011-38 treats a direct transfer of part of an annuity’s value to another annuity as tax-free if no money is taken from either contract during the 180 days after the transfer, with limited exceptions. It applies to annuities, not to life insurance.

How the exchange is done

The mechanics matter. In Rev. Rul. 2007-24, the IRS held that an annuity owner who received a check and endorsed it to a second insurer did not have a tax-free exchange under §1035(a)(3). The amount was taxable. That ruling involved annuities, but the lesson applies broadly: the value should move directly between insurers, or the old contract should be assigned to the new insurer.

A typical 1035 exchange life insurance process looks like this:

1. Get an in-force illustration and the current surrender value, loan balance and cost basis from the old insurer.
2. Apply for the new policy and complete underwriting.
3. Sign the new insurer’s 1035 exchange or absolute assignment form and the state’s replacement forms.
4. The new insurer requests the funds directly from the old insurer.
5. Keep the old policy in force until the new policy is issued and the transfer is confirmed.
6. Keep copies of everything. You’ll need the basis records when the new policy eventually pays out or is surrendered.

Transfers can take weeks. Ask both insurers how they handle premiums due while the paperwork is in process.

Policy loans and “boot”

Loans are where an otherwise tax-free swap can create a tax bill. The §1035 regulation says that if an exchange would qualify except that you also receive money or other property, the rules of §1031(b) and (c) apply. In plain terms, gain is taxed up to the amount of that extra value, often called “boot.”

A policy loan can become boot. Under Treas. Reg. §1.1031(b)-1(c), when a liability is assumed or property is transferred subject to it, that amount is treated as money received. If your old policy has a loan and the exchange wipes it out instead of carrying it to the new policy, the loan relief can be treated like cash you received.

Ways owners handle a loan before a 1035 exchange life insurance swap:

• Carry the loan over to the new policy, if the new insurer allows it.
• Repay the loan with outside money before the exchange.
• Accept the tax on the boot, if the amount is small and the other benefits are large.

Which option is available depends on the insurers involved. Ask both before you sign.

Hypothetical example: exchange vs surrender with a loan

Hypothetical example. Paul, 66, owns a universal life policy with $80,000 of cash value and a $20,000 policy loan, so the net value is $60,000. He has paid $50,000 in premiums, which is his cost basis. His gain inside the policy is $80,000 − $50,000 = $30,000.

In option C, Paul recognizes $20,000 of income even though he received no cash. In option B, nothing is taxed now, and his $50,000 basis carries into the new policy. Option B only works if the new insurer accepts a loan in the exchange. These figures are made up, and the actual tax treatment of a loan in an exchange should be confirmed by a tax professional before acting.

MEC status and business-owned policies

A 1035 exchange life insurance swap can carry tax labels with it. Under IRC §7702A(a)(2), a contract received in exchange for a modified endowment contract (MEC) is also a MEC. You can’t wash MEC status away with a 1035 exchange. Our guide to borrowing against whole life explains why MEC status matters for loans and withdrawals.

The new policy can also become a MEC on its own. Section 7702A(c)(3) treats a material change in benefits or terms as a new contract for the 7-pay test. Putting a large cash value into a policy with a smaller death benefit can fail that test. Ask the new insurer to confirm in writing whether the new policy will be a MEC.

Business owners have one more check. Under IRS Notice 2009-48, a §1035 exchange of an employer-owned policy that involves a material increase in the death benefit or another material change (other than a change of insurer) is treated as issuing a new contract. That can require new written notice and consent from the insured employee.

Surrender charges and other costs

Section 1035 solves the tax problem, not the cost problem. A 1035 exchange life insurance swap can still lose you money in these ways:

• Surrender charges on the old policy. Many cash value policies charge a fee if surrendered in the early years. The charge reduces the value that moves to the new insurer.
• New charges on the new policy. A new policy starts with its own early-year costs. The Massachusetts replacement notice says low cash values in early policy years are often the result of high expenses of issuing a new policy, and that a replacement policy may never provide benefits equal to the old one.
• A new contestable period. Massachusetts law requires life policies to become incontestable after two years in force during the insured’s lifetime. A new policy starts that two-year clock again from its own issue date.
• Higher cost of insurance at an older age, since the new policy is priced on your current age and health.
• Lost features, such as a guaranteed interest rate or a rider no longer sold.

A replacement can still make sense after all of that. The point is to compare guaranteed values side by side, not just the projected ones.

A 1035 exchange life insurance swap is often not the right move when:

• The old policy’s surrender charge is still high and ends in a year or two. Waiting may cost less.
• Your health has declined, so the new premium would eat up the benefit of the exchange.
• The old policy has a guaranteed rate or rider that today’s policies don’t offer.
• You only need a smaller death benefit. Reducing the face amount on your current policy may do the job, though it can affect MEC testing.
• You need the cash soon. An exchange keeps the money locked inside a contract.

If the old policy is term coverage with no cash value, there is nothing to exchange. Ask instead whether it can be converted. Our term conversion guide explains that option, and what happens when term life insurance ends covers the rest.

Life insurance replacement rules in Massachusetts

Every 1035 exchange life insurance swap is also a life insurance replacement under state rules. In Massachusetts, the rule is 211 CMR 34.00, The Replacement of Life Insurance and Annuities. It defines replacement broadly: any purchase of new life insurance or an annuity where existing coverage is lapsed, surrendered, converted to reduced paid-up or extended term, reduced, reissued with less cash value, or borrowed against for more than 25% of its loan value.

When a life insurance replacement is involved, the regulation requires the agent to:

• Present a “Notice Regarding Replacement,” signed by both the applicant and the agent, no later than when the application is taken, and leave it with the applicant.
• Leave the applicant the originals or copies of any written sales materials used.
• Get a list of the policies being replaced, by insurer, insured and contract number.
• Submit a copy of the notice with the application.

The replacing insurer must notify the existing insurer in writing, with a policy summary, within seven working days. It must also give you an unconditional right to a refund of all premiums paid, if exercised within 20 days of the policy’s delivery. Keep that window in mind when the new policy arrives.

The existing insurer may contact you to try to keep your business. The regulation calls this “conservation.” Hearing both sides is useful. Note that the regulation text we reviewed is dated 1996, so confirm the current version with the Division of Insurance.

1035 exchange life insurance: frequently asked questions

Can I do a 1035 exchange from an annuity to life insurance?

Not tax-free. The Treasury regulation says exchanging an annuity or endowment for a life insurance contract is not covered by §1035, and any gain is recognized.

Do I have to stay with the same insurance company?

No. The new policy can come from a different insurer. The value should move directly between the companies.

Can I change the insured person in a 1035 exchange?

No. The regulation requires the policies to relate to the same insured.

What happens to my policy loan in an exchange?

It can be carried to the new policy if the insurer allows, or repaid first. If it is extinguished in the exchange, the loan relief can be treated as boot and taxed up to your gain.

Is a 1035 exchange reported to the IRS?

IRS Publication 525 says you should receive Form 1099-R when you surrender a policy for cash. For a 1035 exchange life insurance swap, ask both insurers which tax forms they will issue, and keep your own basis records.

Will I need a medical exam for the new policy?

Usually you will go through full underwriting for a new life policy. Some smaller amounts qualify for no-exam underwriting. Either way, the new insurer prices the policy on your current age and health.

How long do I have to cancel the new policy in Massachusetts?

For a replacement, 211 CMR 34.00 gives you a right to an unconditional refund of premiums paid if you exercise it within 20 days of delivery.

Review your old policy with an independent agency

Octans Insurance is an independent life and health insurance agency based in Massachusetts. Our licensed agents can review an in-force illustration of your current policy, compare replacement options across the 120+ carriers we work with, and walk you through the 1035 exchange life insurance paperwork, including the replacement notice. If keeping your current policy is the better choice, we will tell you. There is no fee for our help. Call (617) 935-9220. For the tax side, also talk with a CPA.

Keep Reading: Related Guides

• Borrow against whole life insurance
• Whole life insurance
• Is life insurance taxable?
• Life insurance glossary

Important: Octans Insurance agents are licensed in the states in which they operate. Coverage availability and rates may vary by state. Premium examples, when provided, are illustrative samples from published sources, not quotes. Final rates are determined by the insurance carrier based on underwriting and applicable policy criteria. Policy terms, exclusions, limitations, riders, and availability vary by carrier and state.

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