1035 Exchange is an IRS allowed transaction for non-taxable or “tax-free” exchanges between certain types of life insurance and annuity contracts under the concept of like-kind exchanges.
An 1035 Exchange often happens because after a review of an existing life insurance and annuity contract, it was found that a more cost efficient contract with better guarantees and/or rate of return is available, therefore the desire of a transfer of the existing cash value to a new contract via a 1035 exchange.
Normally, when a life insurance policy or an annuity contract is surrendered, if the gross cash value of the contract exceeds the owner’s basis in the contract, gain is immediately taxed as ordinary income. However, when properly structured, an 1035 exchange provides that in some instances where the surrender proceeds from the original contract are transferred into a new contract, there will be no tax on gain at the time of the exchange. Taxation of the gain is not forgiven but rather delayed through the use of “carryover” basis since the income tax basis of the old contract carries over to the new contract.
In our next blogpost, we will discuss the guidelines IRS allows for the 1035 exchanges.