1035 Exchanges: How Tax-Free Policy Swaps Work and Their Limits

If your permanent life insurance policy has built up cash value above what you paid in, cashing it out can trigger income tax on the gain. A 1035 exchange is the federal tax rule that lets you move that value into another qualifying contract without recognizing the gain at the time of the exchange.

It's named for Section 1035 of the Internal Revenue Code, and it comes up whenever someone proposes swapping one policy for another. The tax break is real, but it comes with strict conditions, and a tax-free exchange can still be a poor decision for other reasons.

This guide is general information, not tax, legal, financial or insurance advice. Exchanges involve your specific basis, loans and policy terms, so talk with a tax professional and a licensed insurance professional before you sign anything.

Which exchanges qualify

The statute (26 U.S.C. 1035, as published in the 2024 edition of the U.S. Code) says no gain or loss is recognized on exchanging:

• a life insurance contract for another life insurance contract, an endowment or annuity contract, or a qualified long-term care insurance contract;
• an endowment contract for another endowment contract that begins regular payments no later than the old one would have, or for an annuity contract or a qualified long-term care insurance contract;
• an annuity contract for another annuity contract or a qualified long-term care insurance contract; or
• a qualified long-term care insurance contract for another qualified long-term care insurance contract.

Notice the direction. The Treasury regulation on these exchanges (26 CFR 1.1035-1) states that the section doesn't apply to exchanging an endowment or annuity contract for a life insurance contract, or an annuity for an endowment contract, and that gain or loss is recognized in those cases. In other words, you can generally move from life insurance into an annuity tax-free, but not from an annuity back into life insurance.

The regulation also says Section 1035 doesn't apply if the contracts don't relate to the same insured. FINRA's investor guidance describes the life insurance version the same way: exchanging a policy you own for a new policy insuring the same person.

It has to be an exchange, not a cash-out

FINRA's 2023 investor insight on policy exchanges puts the key condition simply: the old policy must be exchanged for the new one, and you can't receive a check and apply the proceeds to a new policy. In practice, ask both insurers how they will process the exchange so the value moves directly from the old contract to the new one. If you surrender the old policy, take the money and then buy a new policy, the surrender is generally taxed under the ordinary rules: IRS Publication 525 (2025) says you include in income any surrender proceeds above your cost in the policy.

When part of an exchange is taxable

An exchange can be partly taxable. The Treasury regulation says that if you receive money or other property in addition to the new contract, the rules of Section 1031(b) and (c) apply. The IRS's 2026 Instructions for Forms 1099-R and 5498 add a point many people miss: the distribution of other property or the cancellation of a contract loan at the time of the exchange may be taxable and reportable on a separate Form 1099-R.

That matters if your old policy has an outstanding loan. FINRA lists "a potential tax on outstanding policy loans" among the possible unfavorable tax consequences of surrendering an existing policy. Before the exchange, ask both insurers in writing whether the loan will carry over to the new contract or be paid off, and have a tax professional review the result.

Two more tax details:

• Basis. The regulation says the basis of a contract acquired in a 1035 exchange is governed by Section 1031(d), which generally means your cost basis carries over to the new contract rather than starting fresh.
• Modified endowment contracts. Under 26 U.S.C. 7702A (2024 edition of the U.S. Code), a contract received in exchange for a modified endowment contract is itself a modified endowment contract. A policy with that status keeps it when exchanged, and loans and withdrawals from it are taxed less favorably. See our guide to policy loans for what that means.

How the IRS sees the paperwork

According to the IRS's 2026 Instructions for Forms 1099-R and 5498, insurers generally report 1035 exchanges on Form 1099-R using distribution code 6, with a zero taxable amount for a reportable tax-free exchange. Reporting isn't required for certain exchanges within the same company when no distribution occurs and the company keeps adequate records of your basis. If you receive a Form 1099-R after an exchange, check the code and taxable amount and ask the insurer to explain any figure you don't expect.

A tax-free exchange can still be a bad trade

The tax code decides whether you owe tax today. It says nothing about whether the new policy is better. FINRA's 2023 guidance lists reasons an exchange might not be a good idea:

• Part of your built-up cash value may go toward the new policy's first-year expenses, including commissions.
• Surrender charges on the old policy can reduce the value that moves over, and the new policy will likely have its own surrender charge schedule, which may run longer.
• Premiums may be higher if your health has declined.
• The new policy typically starts a new two-year contestability period, according to the same 2023 FINRA guidance.

FINRA also notes that "1035 exchange" is often used loosely for any replacement, but not every replacement qualifies, so not every replacement is tax-free. A 1035 exchange generally still counts as a replacement under state insurance rules, so you should receive the replacement notice and disclosures described in our guide to replacing a policy.

Questions to ask before you sign

1. Does the receiving contract fall into a category Section 1035 allows for my old contract?
2. Is the same person insured under both contracts?
3. Will the value move directly between insurers, with no check made out to me?
4. Is there an outstanding loan on my old policy, and what happens to it in the exchange?
5. What surrender charge will the old insurer deduct, and what surrender schedule applies to the new contract?
6. Is my old policy a modified endowment contract, and could the new one become one?
7. What features, guarantees or riders will I lose?
8. What commission will the agent earn, and could my current policy be changed instead?

Your state insurance department can confirm that an agent is licensed. For variable life insurance or variable annuities, FINRA and your state securities regulator also take complaints.

Key takeaways

• Section 1035 lets you exchange life insurance for life insurance, an annuity, an endowment or a qualified long-term care contract without recognizing gain at the time.
• Exchanging an annuity for a life insurance policy does not qualify, according to the Treasury regulation.
• The old contract must be exchanged directly; taking a check and buying a new policy generally isn't a 1035 exchange.
• Cash received or a policy loan canceled during the exchange may be taxable.
• A tax-free exchange can still cost you through new charges, new surrender periods and a new contestability period.

Sources

• U.S. Government Publishing Office, 26 U.S.C. 1035, Certain exchanges of insurance policies (2024 edition)
• Electronic Code of Federal Regulations, 26 CFR 1.1035-1, Certain exchanges of insurance policies
• Internal Revenue Service, Instructions for Forms 1099-R and 5498 (2026)
• Internal Revenue Service, Publication 525, Taxable and Nontaxable Income (2025)
• U.S. Government Publishing Office, 26 U.S.C. 7702A, Modified endowment contract defined (2024 edition)
• FINRA, Should You Exchange Your Life Insurance Policy? (January 23, 2023)
• National Association of Insurance Commissioners, Life Insurance and Annuities Replacement Model Regulation, MDL-613 (2015)