A 1035 exchange is a specific transfer of funds from one life insurance policy, endowment policy or annuity policy with no gain or loss, meaning it is not taxable. 1035 is actually the section of the tax code that provides for this transaction. This means an individual must qualify based on the exact laws of the tax code in order to pay no taxes on such an exchange. While a 1035 exchange is complicated and should only be done with the assistance of an accountant, there are a few things every person can understand.
1035 Exchanges Preserve Wealth
The main reason to move forward with this type of exchange is because your previous policy is outdated or needs revised. You may even be looking to place your policy with a different company. In either case, you want to make sure the wealth you have built up in your existing policy is not lost. In some cases, you will lose money on your existing policy if you elect to sell or surrender it.
For example, you have made payments totaling $15,000 on a life insurance policy. If you surrender the policy now, you will only gain $10,000, meaning you will lose $5,000 on the deal. With a 1035 exchange, you can transfer the entire $15,000 of payments you have made toward your own policy into your new policy. You will not lose any wealth in the exchange; instead, you will have a new contract with the same cost basis you already provided.
1035 Exchanges Are Not Taxed
Once you have decided it is time to change your policy contract, you will want to ensure you qualify for the no tax option. If you do not carry out the transaction with zero gains, any gains you do make will be taxable. This means you cannot take the $15,000 cost basis from the example above and turn it into a policy that would pay out $20,000 the same day. If you did that, you would be gaining money, and you would be taxed on that gain.
Other requirements ensure the same insured is listed on the new policy and the old policy. There is no limit to how many policies you can transfer in one 1035 exchange. However, all policies in one exchange must have the same listed insured and owner. You can opt for immediate annuity payment options in place of deferred annuity payment options, but there are some restrictions in doing this such as when the payments will start.
1035 Exchanges Are Completely Legal
There are very few ways to benefit financially in the United States and legally not pay taxes, but this is one of them. It is important to understand that section 1035 is written into the tax code for a purpose. The government wants to make it possible for people to change their policy options without being penalized. Nothing about the act of completing a 1035 exchange is illegal unless it is done dishonestly. Failure to disclose the exchange will result in both the standard tax as well as potential civil and criminal penalties.
How long is the 1035 exchange process?
The length of a 1035 exchange depends in part on what you are exchanging. For example, you can use a 1035 tax deferral to exchange annuities or real estate. You will face a specific time constraint between 45 and 180 days in order to replace the property you sold and pick up a new property of equal value. In doing so, you can forgo paying taxes on the sold property for the time being. Remember: you must pay taxes on the profits in the future. A 1035 exchange allows you only to defer taxes, not skip out on paying them all together.