IRC Section 1035 allows Tax Free Exchanges of life insurance policies in a gain position (i.e. gross cash value greater than adjusted cost basis) so that cash values can be easily transferred to more financially efficient policies. Sometimes greater death benefit and/or lower premium can result from the exchange in addition to desirable contract guarantees.
Some of these exchange transactions involve existing contracts where Policy Loans plus Accrued Interest have previously been taken by the policy owner. These loans may have been either an actual cash loan from the policy or through an automatic premium loan (APL) provision.
What are the tax consequences of Discharging (eliminating) a Loan on the old policy during the process of an exchange to a new policy? And what are the tax consequences of Carrying Over the Loan to a new policy? Conversely, what are the tax consequences of Paying Off a Loan on the old policy during the process of an exchange to a new policy?
Unsuspecting policy owners may inadvertently generate taxable income when executing an apparent tax free exchange if care is not taken on exchanges of policies with loans. Here are a few tips about doing Section 1035 exchanges on insurance policies with loans to avoid the unintended result of taxable income
Basic Taxation of Section 1035 Exchanges of Policies with Loans
- When no loans exist on a policy, the exchange of an old policy in a gain position is tax free
- When existing loans are discharged (eliminated) during the exchange of an old policy in a gain position, the LESSER of the policy loan or the policy gain is currently taxable as “boot” income (Treas. Reg. 1.1031(b)-1(c)). The old carrier will issue a Form 1099-R showing the amount of taxable “boot” income. The new policy will be issued without an outstanding loan since the debt (loan) was discharged upon the exchange
- When loans exist on a policy and the loans are carried-over from the old policy in a gain position to the new policy upon the exchange, the exchange is tax free (PLR 8806058; PLR 8604033; PLR 8816015). The new policy is issued with an outstanding loan equal to the loan on the old policy. Verify that the new carrier will accept this carry over loan on the new policy
Multiple Scenarios Where Policy Loans are Paid Off Either Before the Exchange or After the Exchange
For purposes of the four loan pay off situations illustrated below, assume the following facts:
- Face Amount : $1,000,000
- Adjusted Cost Basis: $200,000
- Gross Cash Value: $300,000
- Policy Loans Plus Accrued Interest: $50,000
So, the net cash value is $250,000 and the tax deferred built-in gain is $100,000. What are the loan pay off options both pre-exchange and post-exchange?
- Situation #1 ….. Pre-Exchange Pay Off of $50,000 Loan via $50,000 Cash Withdrawals from the Old Policy
The IRS held in PLR 9141025 that a cash withdrawal from an existing policy to pay down a loan will be treated as taxable “boot” income if it occurs shortly before the exchange to the new policy. Based on the policy facts above, this would result in $50,000 of taxable “boot” income upon the exchange.
This risk may be diminished somewhat if the loan pay off is completed long before the exchange. The question revolves around what is a reasonable time interval between the pay off of the loan and a life insurance policy exchange? Some experts feel that at least one year should lapse. Others are comfortable with a six month interval, especially if the steps to the transaction occur in separate tax years. Clients are urged to consult their tax advisors on this fact pattern.
- Situation #2 ….. Pre-Exchange Pay Off of $50,000 Loan Using $50,000 Personal Funds from Outside the Policy
Use of personal funds to pay off the loan prior to the exchange would NOT be “boot” income since the policy owner is NOT receiving any cash from the policy
- Situation #3 ….. Post-Exchange Pay Off of $50,000 Carried Over Loan via $50,000 Cash Withdrawals from the New Policy
In PLR 8816015, IRS held that a post-exchange cash withdrawal from a new policy to pay down a Section 1035 carried over loan did NOT result in “boot” income. The carry over of the loan to the new policy was held to be a tax free exchange. And the subsequent withdrawal from the new policy to pay off the loan was held to be a tax free withdrawal of cost basis under IRC Section 72(e)(5).
Nevertheless, it may be prudent in light of PLR 9141025 (see pre-exchange Situation #1 above), to let a reasonable time interval lapse between the carried over loan and the withdrawal to pay off the loan. Again, what is considered a reasonable time interval between the policy exchange and the subsequent withdrawal to pay off of the loan has not specifically been addressed by IRS.
- Situation #4 ….. Post-Exchange Pay Off of $50,000 Carried Over Loan to New Policy Using $50,000 of Funds from Outside the Policy
Use of personal funds to pay off the carried over loan after the exchange would NOT be “boot” income since the policy owner is NOT receiving any cash from the policy.
A Section 1035 exchange offers a policy owner an opportunity to increase death benefit and/or decrease premium outlay. When a Guaranteed Death Benefit Universal Life (UL) contract is involved, these “no-lapse” provisions offer strong financial guarantees which may not be available with other types of permanent insurance.
The details of Section 1035 transactions can be complex and require careful analysis. Section 1035 exchanges of policies with loans may apply to corporate owned, personally owned, or trust owned policies. Remember, the policy owner must be the same both before and after the exchange. And multiple life insurance policies can be exchanged (2 or 1; 3 for 1etc.) as long as each existing policy has the same owner. Contact your BSMG Life Insurance Advisor today to discuss the details of your case and let us offer our expertise to enhance your client’s financial security.
Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group