The Loan-Heavy 1035 Exchange
Marcus, 58, owns a $500,000 universal life policy issued in 2011. The account value is $118,000, he has a $64,000 outstanding policy loan at 6%, and his cost-of-insurance charges rose again this year. He has paid $95,000 in premiums, so his basis is about $95,000. The surrender charge has expired. An agent proposes a 1035 exchange into a new indexed universal life policy with a $350,000 death benefit, saying Marcus can 'carry the loan over' and avoid taxes. Marcus had a drug-eluting stent placed eight months ago and takes two medications; the new carrier's underwriting is unknown. He is considering surrendering the old policy first to get cash for the new premium. His wife is the primary beneficiary, and he has two children in college.
1. Is the proposed 1035 exchange tax-free, and how does the $64,000 loan affect that answer?
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Start with two rules. First, IRC section 1035 lets a life-to-life exchange avoid current tax on gain. Second, a policy loan is treated like a distribution if it is not carried over or repaid as part of the exchange. Here the loan ($64,000) is less than basis ($95,000), so even if the loan is treated as boot, there is no gain from the loan alone; boot is taxable only to the extent it exceeds basis. The agent's 'carry the loan over' statement is incomplete: the new carrier must agree to assume the loan, or Marcus must repay it. Many carriers require repayment at the exchange. If Marcus instead surrenders, he is treated as receiving the full $118,000 cash value; $118,000 minus $95,000 equals $23,000 of ordinary income. The loan is not subtracted in computing gain; it is paid from the proceeds, leaving about $54,000 net cash. Also, a large single premium into the new indexed policy could make it a modified endowment contract, changing how loans and distributions are taxed.
2. Identify the replacement and suitability risks in the agent's proposal, including the health issue.
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Replacement risks include: (a) a new two-year contestability period and a new suicide clause; (b) new surrender charges and higher cost-of-insurance at age 58; (c) the death benefit falls from $500,000 to $350,000 while the loan still must be serviced; and (d) the stent placed eight months ago may produce a rating, exclusion, or decline. If Marcus surrenders first, he is uninsured during underwriting and could be left with no coverage. Suitability concerns: the agent is comparing a current policy with a new illustration, but indexed universal life crediting is not guaranteed. The agent should compare guaranteed charges and guaranteed death benefits, not just a projected cap. Oklahoma replacement rules require a replacement notice and comparison, and the free-look period gives Marcus time to reconsider. The proper sequence is to apply, be approved, confirm the loan treatment, and only then exchange or surrender the old policy. If the new policy is rated, the higher premium and reduced death benefit should be disclosed in writing.
3. If Marcus surrenders the old policy instead of exchanging it, what is his taxable gain, and what should he do about the loan?
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On surrender, amount realized is the $118,000 cash value; basis is $95,000; taxable gain is $23,000, ordinary income. The $64,000 loan does not reduce the amount realized because the insurer is treated as paying the loan from the cash value. Marcus nets about $54,000 after the loan is repaid, and the insurer reports the $23,000 gain. If the policy were a modified endowment contract, distributions and loans would be taxed income-first, but the total gain would still be $23,000. He should not surrender until the new coverage is issued and in force, because the stent history could leave him uninsured. He could repay the loan with outside cash before the exchange to simplify the transaction, but that requires $64,000. If he exchanges, he should get written confirmation that the new carrier assumes the loan or that it is repaid at closing, and he should confirm the new policy is not a modified endowment contract.