Revenue Ruling 83-38: Taxable Gain on Certain Exchanges
Understand the tax consequences of exchanging financial products. Certain policy swaps are considered taxable events, creating a current liability.
The tax code establishes guidelines for how financial products, such as insurance policies and annuities, can be exchanged. While many of these transactions can occur without an immediate tax liability, certain exchanges are designated as taxable events. The rules govern the movement of funds between these financial vehicles, ensuring that gains are taxed appropriately when an exchange does not meet criteria for tax-free treatment.
Permitted Tax-Free Exchanges Under Section 1035
Section 1035 of the Internal Revenue Code permits several types of exchanges to occur on a tax-free basis. These provisions allow policyholders to replace outdated or underperforming contracts with newer ones without triggering an immediate tax liability. For an exchange to qualify as tax-free, the policy owner and the insured or annuitant must remain the same on both the old and new contracts.
Common permitted exchanges include:
- A life insurance policy for another life insurance policy. This allows an individual to upgrade to a policy with better terms, lower premiums, or a more financially stable insurer.
- A life insurance policy for an annuity contract. This allows a policyholder to convert the accumulated value in a life insurance policy into a stream of future income.
- An annuity contract for another annuity contract. This gives annuity holders the flexibility to move into products with different features or better investment options.
- A life insurance policy for a qualified long-term care policy. This provision recognizes the growing need for long-term care funding and provides a tax-efficient way to repurpose the value built up in a life insurance contract.
Exchanging an annuity contract for a life insurance policy is not a permitted tax-free exchange and would be a taxable event.
Calculating the Taxable Gain
When an exchange of policies does not qualify for tax-free treatment under Section 1035, or when a policy is surrendered for its cash value, the policyholder must calculate the taxable gain. This calculation involves two primary components: the cash surrender value and its cost basis. The cash surrender value is the amount the insurance company pays upon cancellation of the policy. This amount is the accumulated value inside the policy minus any applicable surrender charges.
The cost basis represents the policyholder’s investment in the contract. It is calculated by taking the total amount of premiums paid and subtracting any non-taxable amounts received, such as policy dividends. For example, if a policyholder paid $45,000 in premiums and received $5,000 in non-taxable dividends, the cost basis would be $40,000.
The taxable gain is determined by subtracting the cost basis from the cash surrender value. Using the previous example, if the policy had a cash surrender value of $50,000 and a cost basis of $40,000, the taxable gain would be $10,000. This gain is taxed as ordinary income, not as a capital gain, which often benefits from lower tax rates.