What Is IRS Section 1035 and How Does It Apply to Policy Exchanges?

Swapping one insurance policy for another without triggering taxes can be a valuable financial strategy. IRS Section 1035 allows policyholders to exchange certain insurance contracts while deferring taxable gains, making it a useful tool for managing long-term financial goals.

Qualifying Requirements

To qualify under IRS Section 1035, the ownership of the new policy must match the original. If ownership changes, the IRS may treat the transaction as a taxable event, eliminating the benefits of tax deferral. For example, if an individual owns a life insurance policy and wants to exchange it, they must remain the owner of the new policy.

The exchange must be direct. The policyholder cannot receive the proceeds from the original policy before purchasing the new one. Instead, the insurance company holding the existing policy must transfer the funds directly to the new insurer. If the policyholder takes possession of the funds, even briefly, the IRS may classify the transaction as a surrender, triggering immediate taxation on any gains.

While there is no strict deadline for completing a 1035 exchange, delays can create complications, especially if the original policy is surrendered before the new one is issued. Ensuring a smooth transition helps avoid unintended tax consequences.

Eligible Contract Types

Only certain insurance and annuity contracts qualify for a tax-deferred exchange under IRS Section 1035. Life insurance policies can be exchanged for other life insurance policies, annuities, or long-term care contracts. However, annuities can only be exchanged for another annuity or a long-term care policy—swapping an annuity for life insurance is not allowed.

A life insurance policy or annuity can be exchanged for a qualified long-term care contract, but the reverse is not permitted. This allows policyholders to shift investment-oriented insurance products into coverage for future healthcare expenses.

The contracts involved must also be issued by insurers that meet IRS guidelines. If an exchange includes a policy from an unqualified insurer, the tax-deferred status of the transaction may be jeopardized.

Procedural Steps

Executing a 1035 exchange requires coordination between the policyholder, the current insurer, and the new insurance provider. The first step is selecting a replacement policy that meets the policyholder’s needs. This involves evaluating different insurers, comparing costs, and assessing policy features such as cash value growth, surrender charges, and available riders.

Once a suitable policy is identified, the policyholder must complete the necessary paperwork to request the transfer. Most insurers provide specific 1035 exchange forms, which authorize the direct movement of funds. These forms typically require details about the current contract, including policy numbers, ownership information, and insurer contact details. Errors in this documentation can delay the process or result in an unintended taxable event, so accuracy is critical.

After submission, the new insurer coordinates with the existing one to facilitate the transfer. This process can take several weeks, depending on responsiveness and administrative requirements. Policyholders should monitor the exchange’s progress to avoid unexpected delays. Some insurers may request additional documentation or clarification before finalizing the transaction, so maintaining open communication is advisable.

Partial Exchanges

A partial 1035 exchange allows a policyholder to transfer only a portion of a life insurance or annuity contract’s value into a new policy while keeping the remainder in the original contract. This strategy can help diversify coverage, adjust investment allocations, or secure better policy terms without fully surrendering an existing contract.

A key factor in a partial exchange is the allocation of cost basis and gain between the original and new policies. The IRS generally applies a pro-rata method, meaning both the tax basis and any accumulated gains are proportionally divided between the two contracts. This is particularly important for non-qualified annuities, where withdrawals are typically taxed on a last-in, first-out (LIFO) basis.

If a partial exchange is followed by a withdrawal from either contract within 180 days, the IRS may treat the exchange as a taxable distribution rather than a tax-free transfer, as outlined in Revenue Procedure 2011-38. Policyholders considering a partial exchange should work with a financial advisor or tax professional to ensure compliance with IRS rules and avoid unintended tax consequences.