Tax Implications of Code Section 1035

Situation: In another Counselor’s Corner article, we discuss how Section 1035 permits tax-free exchanges of life insurance policies. That article provided a detailed discussion of how to structure a life insurance exchange to qualify for Section 1035 tax treatment. In a nutshell, to qualify or tax-free exchange treatment under Section 1035 the transaction must be a “like-kind” exchange.

In contrast, if money or other non-like-kind property (referred to as “boot”) is received in the exchange, the transaction will not qualify for tax-free exchange treatment.1 If boot is received as part of a life insurance exchange, gain will be recognized and taxed to the policy owner to the extent of the boot received.2 A situation where unsuspecting policy owners may inadvertently generate taxable income involves exchanges of policies with preexisting loans. Depending on how the transaction is structured, the loan may fall into the trap of being recognized as boot, causing the exchange to be subject to taxation. This Counselor’s Corner provides tips on doing Section 1035 exchanges on insurance policies with loans to avoid taxable income.

Solution: A couple of general points are worth noting before we get into a discussion of the various ways exchange transactions involving policies with existing loans have been structured in an attempt to avoid taxation. First, if the original policy with the loan is in a loss position (policy basis exceeds cash surrender values) there may be less of a concern about complying with Section 1035 requirements.3 This can open more options to structuring the transaction. Second, where the transaction involves several policies, it’s not possible to net one policy gain against another policy loss. The tax status of each policy must be considered. However, while gains and losses cannot be netted, it is possible to avoid tax on the surrender of a policy in a loss position and use the cash to pay off or down the loan on a policy in a gain position.

Clearly, a key aspect in deciding how to structure an exchange is knowing the tax status of the existing policy(s). This means that before executing an exchange you will want to get the tax basis, loan amount, and policy cash value from the original carrier(s) (ask for a taxable gain calculation). Unfortunately, despite its critical importance many skip this step. Now let’s consider some of the ways exchange transactions involving polices with existing loans have been structured. Assume all the following situations involve policies in a gain position (cash surrender value exceeds policy basis).

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