1031 and 1035 Exchanges: What You Need to Know

1031 and 1035 Exchanges: What You Need to Know

Posted by on Apr 21, 2022

1031 and 1035 exchanges - what you need to know-1337190255

If you’ve been paying attention to our company and our blogs, you probably realize that we are experts when it comes to 1031 exchanges. Additionally, our website URL—realized1031.com—should give you a pretty good idea about our knowledge in this area.

To reiterate, the 1031 exchange, also known as the “like-kind” exchange, allows you to defer capital gains taxes and depreciation recapture by exchanging real property held for investment or trade into other real estate of equal or greater value that will also be used for investment purposes or business. 

But let’s say you’re not a real estate investor, and that your portfolio encompasses life insurance policies and annuities. And let’s also say you’re not happy with the performance of these instruments, and you want something else that better aligns with your particular goals.

There’s an exchange for that, too. It’s the 1035 exchange. Specifically, the 26 U.S. Code § 1035 – “Certain Exchanges of Insurance Policies” means the IRS doesn’t recognize a gain or loss if you should exchange life insurance, endowment insurance, long-term care insurance, or an annuity contract for another.

Taxes and Insurance Policies

Getting back to our blogs, we recently pointed out that the IRS won’t tax life insurance payouts to your beneficiaries when you pass away. But if you decide to cash in your policy while still alive (for whatever purpose), those proceeds could be taxed. The same applies to long-term care insurance. The payout likely won’t be taxed. But cashing in the policy, or borrowing against it, might.

When it comes to annuities, you don’t owe income taxes on those, either. That is, until you start drawing income from them. If you take a lump sum out of your annuity, that’s taxed as ordinary income. What if you decide to take payments as an income stream? Still taxed. 

The consistent theme here is that cash surrenders and income draws could mean taxes. But when done right, the 1035 exchange means no tax penalty, as long as you swap one policy for another. 

Comparing and Contrasting Exchanges

Both the 1031 and 1035 exchanges provide you, the taxpayer, with the opportunity to exchange into investments that might better align with your goals or objectives (once again, while avoiding tax penalties). The following chart provides additional information.

 

1031 – “Like Kind” Exchange

1035 – “Certain Policies”

Assets

Real property held for trade or investment

Life insurance policies, annuity contracts, endowments

Target

Real estate of equal or greater value

  • Life insurance for life insurance, endowment, or non-qualified annuity
  • Endowment for endowment or non-qualified annuity
  • Non-qualified annuity for non-qualified annuity

Process

  • Investor targets replacement property or properties
  • Investor finds a qualified intermediary, who takes control of proceeds through the exchange process
  • Properties are exchanged, based on stringent IRS deadlines
  • Policyholder selects replacement policy
  • Policyholder contacts insurers holding existing and targeted policies 
  • Policyholder fills out and submits application for new policy, and a 1035 transfer request form
  • New contract issued

Deadlines

  • 45 days after closing on relinquished property to identify replacement property
  • 180 days after closing on relinquished property to close on replacement property

30 days (the entire process can take up to three weeks)

Ownership

Same entity conducting the exchange must hold the replacement property

Policyholder must remain the same

 

A Good Strategy?

Just because you CAN swap your life insurance policy or annuity into a new one via the 1035 exchange doesn’t mean you SHOULD. Just as you perform due diligence and research on a 1031 exchange, the same process should be used to determine whether moving your current funds or policies into a new one is a good idea. 

A 1035 exchange might not be a good idea if:

  • The cash value earned on your current asset might be directed to the new policy’s or annuity’s expenses (i.e., commission or upfront fees).
  • An early surrender fee is charged, which could erode your current instrument’s cash value.
  • The replacement asset could lead to higher premiums, especially if your health has changed.

Finally, moving forward with a 1035 exchange should occur only after you’ve determined that the action will benefit you and your beneficiaries, rather than the individual attempting to sell you on it.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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