What is the 'Section 1035 Exchange'
The Section 1035 exchange is a tax-free exchange of an existing annuity contract or life insurance contract for a new one. In order for the new contract to qualify as a section 1035 exchange, the policyholder must exchange his existing contract for an equivalent new contract, and the annuitant or policyholder must remain the same. Applying for a new contract and sending a check for the old contract, against the new contract, does not qualify as a 1035 exchange.
BREAKING DOWN 'Section 1035 Exchange'
Section 1035 exchange is a provision of the U.S. tax code that gives a policyholder the ability to transfer funds from a life insurance, endowment or annuity to a policy of a similar type. If funds are correctly transferred from an old policy to a new policy, the exchange can happen under section 1035 without incurring any taxes.
How Is a 1035 Exchange Beneficial?
The benefit of a section 1035 exchange is that the policyholder transferring funds is able to defer any gains. If 100% of the proceeds from an old policy are transferred into a new policy, and if there are no outstanding loans on the original policy, no taxes will be levied on the gain of the original policy at the time of transfer. Conversely, if gains from a policy are transferred without using a 1035 exchange, they are taxed at the policyholder's ordinary income tax rate.
Even if a policy doesn't have a gain, there are still advantageous reasons to conduct a section 1035 exchange. The first benefit is that policyholders can avoid a modified endowment contract (MEC) situation. Sometimes, a policyholder wants to pay future premiums into a new policy, and if the premiums fit within the 7-pay limit , he can do so through a section 1035 exchange. This allows him to avoid creating an MEC, which is the act of simply surrendering an old policy and purchasing a new one. Avoiding a MEC ensures that the new policy has a higher initial cash value than it would otherwise.
Additionally, a section 1035 exchange allows a policyholder to preserve his basis, even if there are no gains to be deferred. For example, if the basis of an original policy contract is higher than its gross cash value, which means that is suffering a loss, a 1035 exchange allows a policy owner to carry over the higher basis to a new contract. In this scenario, the original contract's tax basis becomes the new contract's basis. Traditionally, the lesser amount of the gross value and the tax basis is placed in a new contract.