Unless you peruse the IRS tax code regularly, you may not be familiar with the code sections 1035 or 1031. However, in the world of wealth building and asset protection, these little combinations of numbers get a lot of attention for good reason.
Simply put, these IRS code sections allow for the transfer of asset values without capital gains taxes.
This article will focus on tips for a 1035 exchange life insurance to be successful, and will draw some analogies to the 1031 exchange for real estate as a way to help clarify this concept of upgrading.
You might also be interested in our article 1035 Exchange for Annuities.
1035 Exchange Life Insurance
I often draw analogies between the characteristics of real estate and whole life insurance as an asset. The reasoning goes something like this…
real estate often requires a fairly steep down payment
real estate is costly in the early years of ownership but can deliver big returns in the long run
real estate offers income tax advantaged cash flow
real estate offers other tax advantages
real estate builds equity that can serve as collateral for loans
real estate is a wealth builder
You may or may not be familiar with these characteristics of real estate. Yet, you should know that you can seamlessly substitute “whole life insurance” for “real estate” in all of the above respects. The type of permanent life insurance that is most widely known is whole life, which embodies these same characteristics found in real estate.
A proper understanding of this fact can diffuse many of the noted objections to whole life insurance, as touted by folks like Dave Ramsey, such as the fact that whole life more costly then other types of permanent life insurance.
How does the above relate to the 1035 exchange…
Another major advantage of real estate is the ability to transfer the cash value (or equity) from one similar (or “like kind”) ASSET to another. In the same way, the IRS has allowed a policy owner to transfer cash value from one life insurance policy to another.
Let’s unpack this concept further…
In real estate, the 1031 exchange is based on the well known IRS code section that allows 1 parcel of investment real estate to be sold and the proceeds used to purchase another with no tax consequences. There are parameters for this and the transaction must occur within specific timelines.
In life insurance, the 1035 exchange is based on the IRS Code section that allows a policy holder to transfer policy cash value to a new policy without tax consequences. Here, as in real estate, specific requirements must be met.
Also, there are good reasons to change to a new policy as well as not so good reasons and these must be understood and reviewed with the policy owners in detail.
However, both 1031 and 1035 exchanges require very specific steps and timelines to follow in making sure that all is compliant from a tax standpoint. Please see our companion article for more on 1035 exchange tax benefits.
1035 Exchange Life Insurance
[Analogous to 1031 Real Estate Exchanges]
In the world of real estate investment, real property is typically exchanged because a larger or more suitable property is located. Rather than sell the existing real property and purchasing another, thereby incurring capital gains taxes, the 1031 exchange is allowed.
For 1031 exchanges, a qualified intermediary is used to hold the proceeds from the original property, and a suitable replacement must be located within 90 days in order to avoid capital gains.
Possible reasons that real estate investors may consider a 1031 exchange may include a) deterioration or excessive cost of current location; b) need for additional space; c) favorable economic changes; d) other changes in circumstances.
In the world of cash value life insurance, the IRS allows a similar advantage if the policy owner identifies a more advantageous life insurance product.
Possible reasons that a policy owner may benefit from a 1035 exchange may include
a) financial uncertainty with current company;
b) new products offering more favorable options, returns, premiums, etc.;
c) favorable (or unfavorable) economic changes for the policy owner;
d) health changes that allow for a better rating with new policy (such as stopping smoking);
So, a 1035 exchange life insurance may be a highly advantageous tool for moving to a better life insurance policy. Still, there are some considerations that everyone needs to know before taking next steps to make this happen.
Using 1035 Exchanges to Change Life Insurance Policies [6 Key Concerns]
- Is there an outstanding loan on the current policy?
- Is there a need to change the owner or insured for the new policy?
- Is there a need for a loan from the new policy soon?
- Is there a need to take part of the proceeds to extinguish a loan or in cash?
- Is the insurance company you are currently exchanging financially sound?
- Is there possibility that the new policy will become a modified endowment contract (MEC)?
Outstanding Policy Loans and 1035 Exchange Issues
We often talk about the advantage of using policy loans as a personal financing system for strategies such as infinite banking. However, if there is an unpaid policy loan on your current life insurance policy, it must be paid back (if funds are available) OR the policy could be “reduced” prior to the 1035 exchange.
If you plan on reducing your policy, you should consider a few important precautions:
a) the reduction can’t exceed the tax basis (the amount invested) in the original policy or a tax will follow;
b) the original policy reduction should be completed well in advance of the exchange to avoid a “step transaction”;
c) there may be a “forced out gain” for recent policies if within the first 15 years of the policy;
d) if the new policy is denied it may be difficult to restore the original coverage.
A loan rescue may be used if a policy loan can be moved to a new policy and if this allowed, the loan could then be paid off with no recognition of taxable gain.
Changes of Policy Ownership or the Insured and 1035 Exchange Issues
Changes in ownership of the policy are NOT allowed with 1035 exchanges. Attempting to change ownership with a 1035 exchange will typically result in income tax AND/OR gift tax consequences. If a change in ownership of the policy is desired, this should be accomplished prior to the exchange.
Some of the same precautions mentioned above would apply here. For example, if the new policy is denied, is the old policy adequate given the change in ownership.
Changes in the insured are NOT allowed either as this would be the same as surrendering an old policy and issuing a new one to a new insured.
Second to Die Policies and 1035 Exchanges
Many people don’t know that a second to die life insurance policy converts to a single life policy for purposes of the 1035 rule upon the passing away of a spouse. Thus a surviving spouse is free to roll that policy into a new one if it is suitable and conditions are favorable to do so.
New Policy Loan Issues with 1035 Exchanges
If a new life insurance policy loan is needed fairly soon, this may cause an issue with a 1035 exchange because it may be deemed a “step transaction”. To be safe, it is recommended to wait a reasonable time after the completion of the 1035 exchange before taking addition policy loans.
Practice Tip: When talking about waiting a reasonable time, my rule of thumb is at least 6 months, however this is really a common sense test based upon the circumstances.
Taking Cash to Extinguish Loans or Other “Non-Like Kind” 1035 Exchange Issues
1035 Exchanges require a “like kind exchange”. Going back to our analogy to real estate, the investor in a commercial property must find a similar commercial property in which to do a 1031 exchange. For purposes of life insurance and 1035 rules, the cash value generally needs to be rolled into another policy. If proceeds are taken out in cash for for repayment, this can trigger tax consequences known as “boot”.
The Company You Are With is Not Financially Sound
Another problem we run into is when a company hits a rough patch and is suffering financially. Certain insurance companies make poor decisions, or other parts of the whole come under financial pressure, effecting the entire company.
For example, when AIG came under financial pressure during the housing crisis, the company’s life insurance division was sound. However, since it was connected to the whole, owners of life insurance policies were fearful of what may happen if AIG went bankrupt.
The Modified Endowment Contract (MEC) and 1035 Exchange Issues
If your current policy is NOT a MEC then the new policy should not have an issue provided it meets the MEC 7 pay rule requirements. However, if the original policy is a MEC, then the exchange policy will also be deemed a MEC. This issue could be especially relevant for an older “grandfathered” MEC policy.
1035 Exchanges are for More than Life Insurance Policies
Remember that 1035 exchanges may ALSO be used for endowments and non-qualified annuities AND may be made interchangeably between life insurance policies, endowments and annuities in many cases.
If you think a 1035 exchange may be advantageous to you, please feel free to connect with us today for help identifying your issues and options.