The 1035 exchange is one of those rare times in which officials with the Internal Revenue Service actually put in place a plan to help individual investors.  1035 exchanges come from the 1030 group of exchanges because they belongs to a section of the tax code on tax-free situations.

Investors who often deal in real estate may be familiar with the 1031 and the 1031 exchange rules.   The IRS naturally wants a cut of any proceeds an investor makes when they buy a property and sell it at a profit.  However, investors can sometimes avoid taxation through a 1031 exchange.  Under this scenario, the investor would simply rollover the profit from the sold property into a new property of equal or greater value, thereby avoiding taxation on gains from the old property.

In a similar way the tax code section 1035 exchange also follows an exchange rolled over rule.  But instead of pieces of property, the investors hold assets such as annuities, life insurance, or endowments, which are then rolled over into new plans with different holding companies, without facing taxes on any gains.

The reasons the holders of such policies might want to switch and take advantage of the 1035 exchange rules, will vary from person to person.  In general assets such as life insurance policies start small and grow over the years.  This build up of assets is often called the reserve.  The provider of the policy keeps the reserve in stocks, bonds and other areas where the funds can build up and earn a profit.  When the policies are left intact, these earnings are not taxable.  But the moment a holder tries to touch them, i.e. taking them out of the policy, such as a loan or withdrawal, the IRS will tax it.  Of course not all the money withdrawn is taxable, just the profit faces these regulations.  This is calculated by subtracting the base investment from the gross.  These are all part of the standardized 1035 exchange requirements, and also apply to a partial 1035 exchange, which only part of the money is withdrawn.

However, if an investor’s policy is not performing as well as they would like, perhaps it was purchased years ago and is no longer competitive with newer policies, they can have the option to rollover their plan to a new company without facing any taxation.  In other words, the IRS will treat the funds as if they haven’t been withdrawn, when they are transferred to the new policy, thereby avoiding unwanted taxes for the investor. However, the investor should understand that a few other taxes could apply with a 1035 exchange, so it’s important to check with the IRS before committing to any exchange.  By the way, you can check out a great type of insurance policy known as return of premium term life insurance to give yourself more life insurance options to choose from.