Section 1035: Swapping Insurance Policies Without Tax
How a life insurance policy or annuity can be exchanged for a better one with no tax on the gain, which exchanges qualify, and what makes an exchange taxable.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
Section 1035 lets the owner of a life insurance policy, annuity, or endowment contract exchange it for another contract without recognizing the gain built up in the old one. The exchange must go directly between insurers, the owner and insured must stay the same, and life insurance can become an annuity but not the reverse.
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Which exchanges qualify?
| From | To life insurance | To an annuity | To qualified long-term care insurance |
|---|---|---|---|
| Life insurance | Yes | Yes | Yes |
| Endowment contract | No | Yes | Yes |
| Annuity | No | Yes | Yes |
| Qualified long-term care | No | No | Yes |
Life insurance can also be exchanged for an endowment contract, and an endowment for another endowment whose payments begin no later than the old one's. The new contract keeps the old contract's basis, so the deferred gain remains inside it.
What makes an exchange taxable?
- Cash received. Taking any cash out in the exchange is taxable to the extent of gain.
- Policy loans. Surrendering a policy with an outstanding loan to fund the new one can make the loan taxable "boot"; carrying the loan over to the new policy, where the insurer allows it, avoids that.
- Indirect transfers. Surrendering the old contract, receiving a check, and buying a new one is a taxable surrender, not an exchange.
- Changing the insured or owner. The exchange must be of a contract on the same insured, owned by the same person.
Why do owners exchange?
A newer policy with lower cost of insurance or better features; moving from a cash-value life policy no longer needed to an annuity that will pay income; consolidating several policies; moving to a carrier in better financial condition; or converting an annuity into one with long-term care benefits, whose payouts can then be tax-free.
What should you check first?
Surrender charges on the old contract (an exchange does not avoid them), surrender charge periods on the new contract, the loss of guarantees in the old contract, whether the old policy is a modified endowment contract (that status carries over), and whether a partial exchange of an annuity — allowed if nothing is withdrawn from either contract for 180 days after the transfer, other than annuity payments for life or for 10 years or more — fits better than a full one.
What about business-owned policies?
Key person and buy-sell funding policies can be exchanged under the same rules. Exchanging a policy on a departing owner's life, or transferring it to a new owner, is not a Section 1035 exchange and can trigger the transfer-for-value rule, which can make the death benefit taxable above the price paid plus later premiums. Those transactions need separate planning.
Frequently asked questions
Can I exchange a policy on my life for one on my spouse's life?
No. The insured must be the same.
Does an exchange restart the surrender charge period?
Usually yes, on the new contract.
Can I exchange a policy with a loss and deduct it?
A loss on a life insurance contract is generally not deductible; an exchange carries the high basis into the new contract.
Does the two-year contestability period restart?
Generally yes. The new policy is a new contract with its own contestability and suicide clauses.
Official sources
The statute provides: “No gain or loss shall be recognized on the exchange of— (1) a contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract;” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 1035 - Certain exchanges of insurance policies, https://www.law.cornell.edu/uscode/text/26/1035
The IRS explains: “If you transfer part of the cash surrender value of an existing annuity contract for a new annuity contract issued by another insurance company, the transfer qualifies for nonrecognition of gain or loss. The funds must be transferred directly between the insurance companies.” — Internal Revenue Service, Publication 575 (2025), Pension and Annuity Income, https://www.irs.gov/publications/p575
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk reviews the exchange paperwork for loans and boot before an insurance swap is submitted. See pricing or book a free fit call.
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