IRS Fixes 1035 Life Insurance Exchange Trap
Transferring a life insurance contract can make sense for any number of reasons—and is often a normal part of portfolio management, particularly for corporate and high-net-worth clients. IRC Section 1035 allows taxpayers to trade life insurance contracts and annuities for new contracts without creating an immediate taxable event. That said, the 2017 Tax Cuts and Jobs Act (the TCJA) created a new concept: the reportable policy sale—adding uncertainty to the tax-free exchange treatment of otherwise-qualifying life insurance contracts. Now, the IRS has finalized regulations to provide much-needed clarity with respect to exchanges of life insurance contracts that qualify for nonrecognition treatment. The new rules are now live, so clients who are considering a life insurance exchange (including via a life settlement or private placement life insurance rebalancing) should understand their application.
Life Insurance Transfers for Value: The Basics
Sales and transfers of life insurance contracts can quickly become complex. The rules are likewise complex. From the seller's perspective, they are responsible for any gain on the sale—unless the contract is exchanged for another eligible contract in an IRC Section 1035 exchange that qualifies for nonrecognition treatment. Section 101 of the IRC excludes the death benefit proceeds received under the contract.
When a life insurance contract is transferred for any type of valuable consideration, the Section 101 death benefit tax exclusion is capped at (1) the consideration paid for the contract plus (2) any subsequent premium payments (unless an exception applies). This is known as the transfer for value rule.
Exceptions include transfers to the insured, a partner of the insured or a corporation in which the insured is a shareholder or officer. The transfer for value rule also does not apply if the basis in the new contract is determined by reference to the basis in the old contract (the carryover basis exception).
The TCJA added a new IRC Section 101(a)(3), adding the concept of the reportable policy sale. A reportable policy sale is a transfer of a life insurance contract (or an interest in one) where no family, business or financial relationship exists between the buyer and the insured person, aside from the interest in the life insurance contract. New IRC Section 6050Y requires reporting of these sales on Form 1099.
The TCJA changes eliminated the carryover basis exception if the transfer was a reportable policy sale. This, in turn, created the risk that a new life insurance contract that was issued in a Section 1035 exchange would trigger the transfer for value rule's limitation on the otherwise-available tax exclusion.
In 2019, the IRS issued regulations providing that the issuance of a life insurance contract to a policyholder, other than in a 1035 exchange, is not considered a transfer of a life insurance policy. This language further confused the treatment of contracts issued in 1035 exchanges.
The IRS Final Regulations
In 2023, the IRS proposed regulations providing that typical Section 1035 exchanges are not treated as transfers for valuable consideration that would trigger the transfer for value limitation. The 2026 regulations finalized this rule. By itself, a Section 1035 exchange is not treated as a reportable policy rule, assuming the original contract was never transferred in a reportable policy sale.
The regulations further provide that if the death benefit under the original contract was fully excludable, the new contract's death benefit remains fully excludable. However, if the original contract's death benefit was limited by the transfer for value rule, that limitation carries over to the new contract.
Similarly, if the receipt of cash or property (known as boot) would have reduced the death benefit exclusion for the original contract, that boot will also reduce the death benefit exclusion for the new contract.
The IRS also simplified reporting obligations by providing that the buyer does not have to report the 1035 transfer on Form 1099-LS.
The regulations also create a very narrow exception that applies in cases involving tax-deferred corporate reorganizations under IRC Section 368. The reportable policy sale rules are not triggered when a corporation acquires a life insurance contract from another corporation in a Section 368 reorganization. This exception only applies assuming that (1) the target corporation is not in the business of investing in life insurance contracts and (2) no more than 5% of the value of the target corporation's assets can consist of life insurance contracts.
The final regulations are effective as of July 9, 2026. Taxpayers can elect to apply the regulations retroactively, to transactions occurring after December 31, 2017.
Conclusion
The new final regulations provide much-needed clarity for interested parties. That said, clients should be advised that they only impact Sections 101 and 6050Y—state laws can potentially change the outcome, and the newly acquired contract must also qualify as life insurance under IRC Section 7702(a). Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.