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1035 Exchange (Taxation) – Definition

Section 1035 Exchange Definition

Replacing a life insurance policy or an annuity with a new one without paying any additional taxes as a consequence of this exchange is referred to as ‘Section 1035 Exchange’ as per the Internal Revenue Code (IRS) of the United States.

A Little More on What is a 1035 Exchanges

A 1035 Exchange provides the benefit of changing annuity schemes without inviting extra taxes. Owners can swap in better performing bonds and shares while discarding outdated and lossy portfolio items without restrictive tax measures limiting their investment options.

It also facilitates policy holders in preserving their basis in the absence of deferred gains. For e.g., X invests $10,000 in a non-qualified annuity. No withdrawals or loans are recorded on this investment. Due to poor performance of the underlying assets, the value of this annuity drops to $8000. X decides to choose better performing options with a different firm in lieu of the poor policy currently in his portfolio. A Section 1035 Exchange facilitates the transfer of this policy at the cost of the original investment of $10,000 as the basis of the new contract, even as the actual value of money transferred is $8000.

How Does A 1035 Exchange Work?

Although a 1035 Exchange facilitates easy swapping in and out of different policies, it doesn’t absolve the owner of any payments due or transaction and operational fee incurred on such exchanges. Transfers within the same firm might have the provision of a transaction fee waiver, but not always. It only allows exchange between similar contracts, for e.g., a Modified Endowment Contract (MEC), can only be traded in for another MEC. There’s no change in the status or nature of the contract. Similarly, a life insurance policy can only be exchanged with another life insurance policy.

Money transfers from one policy account to another are direct and the owners cannot act as intermediaries. Also, owners of old and new policies should also remain the same. 1035 Exchanges do not allow transfer of policies from one owner to another, nor does it allow exchanges between joint account holders. X can’t exchange his policy in for another one where his account also has another owner Y.

Section 1035 Exchanges are very popular as they ease portfolio diversification, even when only a partial policy exchange occurs. In such exchanges, a percentage of the cost basis is diverted towards the new products.

References for Section 1035 Exchange

Academic Research on Section 1035 Exchange

Life Insurance Exchanges Under Section 1035: Think Twice Before You Surrender, Dropick, D. K. (1984). Connecticut Law Review, 17, 525. This paper sheds light on the critical considerations to be pondered upon before exercising a Section 1035 Exchange for life insurance policies.

Taxpayer Was Entitled to Nonrecognition of Gain under Section 1035 on the Partial Exchange of an Annuity: Conway v. Commissioner, (1999). Tax Lawyer, 52(4), 895. This article sheds light on the legal ramifications of nonrecognition of gains under Section 1035 in the case of Conway vs. the Commissioner.

The Federal Income Taxation of Life Insurance, Annuities and Individual Retirement Accounts After the Tax Reform Act of 1986, Manno, T. P., (1986). St. John’s Law Review, 60(2), 674-710. This paper discusses federal tax policies that govern annuities, life insurance, and other policies that can be exchanged under Section 1035.

Revenue Rulings, Seltzer, W. M., (1977). International Tax Journal, 3, 90. This paper sheds light on the foreign tax credits in the U.S. in light of the Section 1035 Exchange tax reforms of 1976.

Sales, Exchanges, and Basis, Handler, A. M., Jensen, E. M., (1999). The Tax Lawyer. 52(4), 1171-1178. This paper looks at the legislation around the gains and losses in sales, exchanges, and the basis in light of the 1035 Exchange code.

A ROADMAP TO THE FEDERAL INCOME TAXATION OF NON-QUALIFIED ANNUITY CONTRACTS: American Bar Association Section of Taxation Committee on Insurance Companies. (1991). The Tax Lawyer, 45(1), 123-164. This chapter deals with the federal tax laws that govern annuity contracts.

The 1954 Internal Revenue Code: Gains and Losses on Sales and Exchanges, Bryson, B. (1956). American Bar Association Journal, 42(7), 628-632. This paper sheds light on the IRS tax codes from 1954 that deal with profits and losses in policy sales and exchanges that do not incur additional taxes.

Financial Transactions, Connors, P., & Van R. Mayhall. (1991). The Tax Lawyer, 44(4), 1279-1285. This paper discusses the special tax rules that are applicable under Section 1035 Exchange codes in case of debt instruments exchanges.

Insurance Companies, Christie, R., & Griffin, M. (2004). The Tax Lawyer, 57(4), 1115-1120. This chapter focuses on the treatment of insurance policies under Sections 1035 and 72 of the IRS Exchange codes, for partial exchanges.

Measuring the Tax Benefit of a Tax-Deferred Annuity, F. Babbel, David & Reddy, Ravi. (2009). SSRN Electronic Journal. 10.2139/ssrn.1281062. This paper discusses the tax benefits of deferred annuities.

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