Generally, the Section 1035 exchange
rules allow the owner of a financial product, such as a life insurance or annuity contract, to exchange one product for another without treating the transaction as a sale--no gain is recognized when the first contract is disposed of, and there is no intervening tax liability.
Under the PPA, a Section 1035 exchange
to a hybrid annuity can bypass that potential tax bite because amounts coming out of the hybrid annuity for LTC expenses are tax-free.
In particular, these changes have converged to create an opportunity to use an Internal Revenue Code Section 1035 exchange
to address potential long-term care funding needs.
Also, if the non-qualified SPIA is part of a Section 1035 exchange
from an existing deferred annuity, this will have a bearing on whether the pre-59-and-a-half penalty tax of 10 percent will apply to the taxable part of the non-qualified SPIA.
The effect of an IRC Section 1035 exchange
on the grandfathered status of a policy issued prior to June 21, 1988, and thus not subject to the seven pay test of IRC Section 7702A is not entirely clear.
A section 1035 exchange
may provide a higher death benefit and cash surrender values than the original policy, but even if it does improve upon the old policy, it may not be the optimal solution.
* Do a partial Section 1035 exchange
, using the proceeds to pay for a standalone LTCI policy
For purposes of a Section 1035 exchange
, an endowment contract is considered a contract "which depends in part on the life expectancy of the insured, but which may be payable in full in a single payment during his life." The exchange of an endowment contract must be made prior to its maturity date.
A section 1035 exchange
on its own will not cause a contract to come under the new rules, but a material increase in death benefit or other material change in connection with the exchange will.
There may be additional complications if the policy was the subject of a Section 1035 exchange
. In this case, the new carrier may have asked the replaced carrier for the old policy's basis so it could be accounted for in the carryover of reported values.
The taxpayer's application to company B expressly requested that the transfer of funds and purchase of another annuity were to be treated as a Section 1035 exchange
. The IRS claimed it was not a Section 1035 exchange
because the entir e company A annuity was not replaced by the company B annuity.
Since a number of financial and tax factors must be considered, the CPA may be in the best position to help a client make an objective determination about the appropriateness of using a section 1035 exchange
to replace a policy.