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Exchanging a policy that carries a loan and where the tax bill hides
How an outstanding loan, cash received and partial exchanges can create taxable gain inside a 1035 exchange, with numbers and a pre-application checklist.
A 1035 exchange is called tax-free, and for a policy with no loan it often is. Add a loan and the label starts to mislead. The loan is borrowed money, not income, so people assume it does not matter to the exchange. But when the old policy goes away, the loan goes with it, and the tax law can treat that disappearance as cash you received. The result can be a tax bill in the year of an exchange that was supposed to defer everything, and a bill that arrives with no cash to pay it.
This post goes through the mistakes that create that bill, one at a time: how each happens, what it costs in a worked example, and how to catch it before you apply. The numbers are hypothetical, and the tax treatment is described in principle. A tax professional should confirm how it applies to your policy before any paperwork goes out.
The rule underneath all of this
The basic idea is the one in the 1035 exchanges: swapping policies without tax guide. If you swap one qualifying contract for another and the value goes directly between insurers, you do not recognize gain at the time. But the swap has to be a swap. If you also receive something else, which tax people call "boot," the gain is taxed up to the amount of the boot. Boot includes cash you receive and, as the guide explains, a loan on the old contract that is not carried over to the new one.
Two figures decide the tax:
- Gain realized: the value of what you gave up (cash value, including the part encumbered by the loan) minus your basis.
- Boot: the cash you receive plus any loan relief.
The gain you must report is generally the smaller of the two. Your basis in the new contract is the old basis, reduced by boot and increased by the gain you recognized. Those formulas sound abstract, so the worked examples below do the arithmetic. For how basis is built from premiums and dividends, see figuring your cost basis in a cash value policy before any withdrawal.
Mistake 1: Assuming the loan quietly goes away
How it happens. An owner has a $30,000 loan from years of borrowing and compounding interest. The new insurer's application asks for the "full value" of the old policy. The old insurer pays off the loan from the cash value and sends only the net to the new company.
What it costs. The following is hypothetical.
Say Dana owns a universal life policy with a gross cash value of $100,000, a loan of $30,000 and a basis of $50,000. She wants to exchange into a new policy.
| Item | Amount |
|---|---|
| Gross cash value given up | $100,000 |
| Basis | $50,000 |
| Gain realized | $50,000 |
| Loan paid off from the old policy (boot) | $30,000 |
| Net sent to the new insurer | $70,000 |
| Gain recognized (the smaller of gain realized and boot) | $30,000 |
| Deferred gain remaining in the new contract | $20,000 |
Dana wanted a tax-free exchange. She gets one on $70,000 and a taxable $30,000 on the loan. The insurer reports the distribution on Form 1099-R, and Dana owes tax at ordinary rates on $30,000 she never held in her hand. Her basis in the new contract is her old basis of $50,000, reduced by the $30,000 of boot and increased by the $30,000 of gain recognized, which leaves $50,000 against a new value of $70,000: the $20,000 of deferred gain.
How to avoid it. Ask the old insurer for a pre-exchange statement showing gross value, loan, accrued interest and the net amount that would transfer. Then ask in writing: "Will the loan be paid off, or carried over?" Ask the new insurer the same question from its side. The life insurance policy loans: how they work and what they risk guide explains how loans accrue.
Mistake 2: Assuming the new contract can take the loan
How it happens. A loan can sometimes be carried over to a new life policy, and in that case no boot arises. Owners hear that and assume it is always possible. It is not. Whether the loan can follow depends on the new insurer and the new product, and many annuity issuers will not accept a policy loan from a life insurance contract at all. If the loan cannot be carried, it has to be paid off, and Mistake 1 follows.
What it costs. Even when a carry-over is allowed, it is not free of risk. Return to Dana. Suppose the new policy accepts the $30,000 loan, so the new contract starts with a gross value of $100,000 and a $30,000 loan, and her basis of $50,000 carries over. No gain is recognized at the exchange. But the loan is still there, accruing interest. If the new policy later lapses while the loan is outstanding, the loan is treated as received, and the gain over basis, here $50,000 plus any later growth, becomes taxable all at once. The tax problem has moved, not disappeared.
How to avoid it. Ask both insurers whether the loan can move, on what terms, and at what interest rate. Ask for an illustration showing the loan in the new contract and whether the new policy can carry it without lapsing. The policy loan calculator shows how an unpaid loan grows.
Mistake 3: Letting the loan exceed the basis
How it happens. Over many years, borrowing and unpaid interest push the loan higher than the premiums paid. The owner decides to "get out" of the policy through an exchange, thinking it avoids a surrender.
What it costs. The following is hypothetical. Say Ravi's policy has a gross cash value of $100,000, a loan of $80,000 and a basis of $50,000.
| Item | Amount |
|---|---|
| Gain realized ($100,000 − $50,000) | $50,000 |
| Loan paid off (boot) | $80,000 |
| Net sent to the new insurer | $20,000 |
| Gain recognized (the smaller of $50,000 and $80,000) | $50,000 |
| Deferred gain remaining | $0 |
Ravi pays tax on the whole $50,000 gain, which is the same amount a surrender would have produced, and holds a new contract worth $20,000. The exchange deferred nothing. If the new insurer's costs and surrender schedule are added, he may be worse off than if he had surrendered and kept his options open. Ask yourself, before exchanging, whether the point of the exchange survives the loan.
How to avoid it. Compare the loan to the basis before you apply. If the loan exceeds the basis, assume the whole gain is taxable and decide whether the exchange still makes sense. The keep, surrender or sell your policy? lays out the keep, surrender and sell alternatives.
Mistake 4: Taking a check for the small difference
How it happens. The old insurer's value is $73,412.88, and the new insurer's form is filled out for $73,000. Someone suggests that the difference, or any rounding or refund of premium, be sent to the owner "so it all balances."
What it costs. Cash that reaches you is boot. A modest check taxed on a modest gain is a small cost, but the larger problem is that the paperwork now shows a payment to the owner, which can complicate the form coding and the explanation to the IRS. If you want the full value to move, say so on the forms, and ask both companies to send everything, including any refund, to the new insurer.
How to avoid it. Put "full transfer, no cash to owner" on the exchange form where the form allows it, and confirm in writing. If a small amount of cash is unavoidable, ask the tax professional how much gain it triggers.
Mistake 5: Withdrawing or borrowing around the exchange
How it happens. An owner takes a withdrawal from the old policy a few weeks before the exchange to cover a bill, or borrows from the new contract soon afterward, thinking the two events are unrelated.
What it costs. The IRS can treat money taken out in connection with an exchange as part of the exchange, which makes it boot. How closely events must be tied together is a facts-and-circumstances question, and there is no clean safe harbor for a life insurance policy that is the equivalent of the one for annuity partial exchanges. In the worst case, the withdrawal is recharacterized as cash received in the exchange, and the gain on it is taxed.
How to avoid it. Treat the weeks around the exchange as a quiet period. Do not take withdrawals or loans from either policy, and do not change the death benefit. If you need cash, handle it before you begin the exchange, discuss it with a tax professional, and document why the two events are separate.
Mistake 6: Treating a partial exchange as simple
How it happens. An owner wants to move only part of a policy's value, perhaps to keep a smaller death benefit and put the rest into an annuity.
What it costs. The IRS's partial-exchange guidance, Revenue Procedure 2011-38, addresses annuity contracts. For a life insurance policy, splitting the contract raises questions the guidance does not settle, and an insurer may refuse to split a life policy at all. If the structure fails, the part you thought was exchanged can be treated as a distribution. A loan makes this worse, because it must be allocated between the part kept and the part moved, and that allocation affects boot.
How to avoid it. Ask the old insurer whether it will process a partial exchange of that policy type at all. Ask the tax professional how the loan would be allocated. If the answer is unclear, consider a full exchange or a different tool, such as reducing the death benefit or taking a withdrawal within basis.
Mistake 7: Overlooking the modified endowment contract
How it happens. The new policy is funded with a large amount from the old one. Nobody tests it against the seven-pay limit.
What it costs. A policy that fails the test is a modified endowment contracts and the 7-pay test. Loans and withdrawals are then taxed gain-first, and a 10% additional tax can apply before age 59½. If the old policy was already a modified endowment contract, the new one generally stays one, and a loan on it is handled under those rules. A loan on a modified endowment contract is taxed like a distribution, so how a loan is handled in an exchange involving one is a point to raise explicitly with the insurers and a tax professional.
How to avoid it. Ask both insurers to state in writing whether the old policy is a MEC and whether the new policy will be one. If you plan to borrow against the new policy, this matters even more.
Mistake 8: Not checking the tax form
How it happens. The exchange closes, the owner relaxes, and a year later a Form 1099-R arrives showing a taxable amount.
What it costs. If the old insurer coded the transfer as an ordinary surrender, the IRS gets a record of taxable income that you did not mean to report. Fixing it after filing means amended returns and letters. A coding error caught early is a phone call.
How to avoid it. Before you file, compare the form's gross and taxable amounts with your own calculation, using the boot arithmetic above. If the insurer shows a taxable amount different from yours, ask for the calculation, not just the number.
Catching the problem before you apply
Use this list before you sign the exchange request.
- Ask the old insurer for gross value, loan, accrued interest, net value and surrender charge, dated.
- Ask for your basis and compare it with the loan.
- Ask both insurers whether the loan will be paid off or carried over, in writing.
- If the loan will be paid off, calculate the boot and the recognized gain with the formulas above.
- Consider repaying the loan from outside funds before the exchange. If you do that with your own money, there is no loan relief to treat as boot, though the cost is cash you must have.
- Ask whether the old and new policies are or will be modified endowment contracts.
- Avoid withdrawals, loans and benefit changes around the exchange.
- Ask a tax professional to run the numbers for your policy before you sign. The a 1035 exchange from application to confirmed transfer walkthrough covers the paperwork that follows, and a lapse with an outstanding loan, worked through to the tax bill shows what a loan does at a lapse.
When the loan changes the answer entirely
Sometimes the right conclusion is not to exchange. If the loan is large, the new contract cannot carry it, and the gain is mostly taxable anyway, the exchange may cost more than it saves. Alternatives to weigh include repaying the loan over time, reducing the death benefit, using nonforfeiture options to stop premiums, or a surrender with a planned tax payment. The point is to decide with the numbers in hand, not to discover them from a tax form.
Key takeaways
- A loan on the old policy that is paid off in the exchange is generally treated as cash received, so gain can be taxed up to the amount of the loan even though no cash reaches you.
- The taxable amount is generally the smaller of the gain realized and the boot; if the loan exceeds your basis, the whole gain can be taxable.
- A loan carried over to a new life policy avoids boot but keeps the lapse risk, and many annuity issuers will not accept a policy loan.
- Avoid checks to yourself, withdrawals or loans around the exchange, and unexplained partial exchanges; get answers in writing before you apply.
- Compare the old insurer's tax form with your own calculation, and ask a tax professional to run the numbers before you sign.