IRS Reporting Rules on 1035 Exchange

You can avoid taxes on an exchange of life insurance policies under Section 1035.

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The Internal Revenue Service will allow you to exchange one life insurance policy, annuity or long-term care policy for another, free of any taxes or penalties, as long as you adhere to certain rules on these exchanges, which are known as Section 1035 exchanges. If the transaction qualifies, no reporting isrequired; exchanges that don't meet the guidelines for Section 1035 treatment appear on Form 1099-R and the individual Form 1040.

Ground Rules

To qualify your exchange as a Section 1035, you must surrender your old life insurance policy or annuity for a new one without receiving any proceeds from the transaction. The company issuing the new contract must receive and cancel the old contract, and the prior contract must pay any cash value directly into the new policy. In addition, the annuitant or beneficiary must be the same individual; you can't exchange an old annuity contract for another, for example, with someone else entitled to the annuity payments on the new contract.

Reporting Rules

If a distribution is made to the policyholder, the company making the transaction must report the proceeds on Form 1099-R, "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts." This is the standard form for reporting distributions from retirement accounts, pensions, insurance contracts and annuities. The IRS also requires reporting of the exchange if the old insurance company canceled a loan as a part of the transaction.

Reporting Waived

The IRS does not require the 1099-R reporting if the policyholder does not receive any proceeds from the transaction under Section 1035 or if he exchanges one contract for another within the same insurance or annuity company. The IRS also requires the company doing the transaction to keep records of the "basis" in the contracts, meaning the amount the policyholder has paid in the form of premiums and as an initial investment.

1040 Reporting

If the exchange is reportable, the insurance or annuity company enters the total value of the life insurance policy or annuity in Box 1 of Form 1099-R, the total premiums paid by the policyholder in Box 5 and "6" as the distribution code in Box 7. If you receive any distribution from the exchange, you report the amount on Line 16 of Form 1040, and the taxable portion of the distribution appears on 16B to join your gross taxable income.

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Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.

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