Secret Codes 1031 and 1035 (exchange)

Secret Codes 1031 and 1035 (exchange)

Last week we talked about 4 ways to tap into the cash of your life insurance policy.  This week, we are taking it to the next level and will outline ways to exchange (or rollover) an existing annuity, life insurance or endowment policy for a better policy whilst deferring tax on the transaction.

Since President Biden has proposed increasing capital gains from the current 20% to 39.6% (let’s call it 40%) for those in the top income bracket, tax loopholes like the 1035 and 1031 exchange become even more valuable.

A 1035 exchange is defined as is a provision in the IRS tax code (1035) allowing for a tax-free transfer (or rollover) of an existing annuity contract, life insurance policy or endowment for another one of like kind.

It is easier to understand the power of 1035 exchanges by using examples of when it is in a client’s best interest to take advantage of this tax loophole.  Scenarios when we used the 1035 exchange to improve client positions over the past 3 years include:

  1. Client has a 20-year old traditional whole-life insurance policy with a $100,000 cash value (earning zero interest) and is interested in a new policy with the long-term-care rider(chronic illness rider): RESULT: We rolled over the cash into a new policy so Mary can now access a portion of her death benefit for long-term care needs (by exercising the new chronic-illness rider while living) should she become ill without having to buy an expensive long-term care policy.  Mary paid NO TAX on her 1035 exchange!
  2. Client’s wife died of Covid-19, so we reviewed his 5 annuities, one of which was only paying 1.2%: RESULT: John had a 10-year-old annuity that had a 7-year rate guarantee of 3.5%.  Unbeknownst to him (John never read his annual statements) his annuity renewal rate dropped to 1.2% in 2018, so he did a 1035 exchange to a new annuity with a different company locking in his rate of 2.75% for 7 years.  John paid NO TAX on his 1035 exchange!
  3. Mark’s 2nd wife (15 years younger than him) just died from Covid-19 and he has a large life insurance policy on himself he feels he no longer needs or wants to pay for.  RESULT: Mark did a 1035 exchange (rolled over his cash value) from his life insurance policy to a fixed annuity paying 3% in New Jersey (where he has a summer home).  Now, he no longer has to pay his life insurance premium and all of his money (cash value) is earning 3% guaranteed (no fees in a fixed annuity) for 10 years instead of the 0% he was earning on his whole-life policy.  Mark paid NO TAX on his 1035 exchange!

DISCLAIMER: The 1035 exchange check must go directly from one insurance company to another.  The policyholder cannot ever receive (called constructive receipt) the check!

The 1035 exchange is a powerful tool for insurance and financial advisors that is under-utilized mostly due to ignorance or a lack of creativity.  There is a similar tool called a 1031 exchange available for real estate. 

DISCLAIMER: Please consult with your realtor, financial advisor, and real estate attorney before deciding if a 1031 exchange is right for you. 

I reached out to interview George Russo over the weekend as I know he has extensive 1031 exchange experience, for an explanation and some tips.

In real estate, a 1031 exchange is a swap of one investment (or business) property for another (considered like-kind) that allows capital gains to be deferred, not eliminated.  It can work if you are looking to sell an investment property, you do not need the money and do not want to pay the capital gains taxes.  Savvy investors use 1031’s to defer capital gains and build wealth!

George said, “it is critical to know the rules and work with experienced advisors when handling these sophisticated transactions.”  Steps he mentioned include:

  1. Sign a contract of sale of your property.
  2. Within 45 days you must “identify” 3 similar properties based on value.
  3. Choose an “intermediary” (remember, like the 1035 exchange you CANNOT ever receive the cash, so the intermediary holds it).
  4. Sell your property.  You now have 180 days to close on the new property.
  5. Close on the new property within 6 months and your basis gets transferred from the old to the new property with no taxation.

Although Covid-19 has its challenges, there are also opportunities to improve your financial position and quality of life for the LONG-HAUL!  

If you are interested in a life insurance or annuity policy review, feel free to reach out to me at [email protected]. 

It has been a joy writing my “Financial Wave” column for The Wave as we approach our 1-year anniversary on May 1st, 2021!