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Question: My client has a $200,000 basis in an NQDA worth $400,000. The client wants to get $200,000 out of the NQDA to buy a house. Under the rules, the entire $200,000 distribution will be taxable and subject to the penalty tax if the client is younger than 59 ½.
I want to know if the client does a partial 1035 exchange of the NQDA—sending half to a new contract—will the client effectively be able to avoid income taxes on half of the $200,000 left in the existing NQDA?
Answer: The short answer is no, based on the information in Revenue Procedure 2011-38. If the client can wait for six months to take a distribution after the partial exchange, the strategy might work. I’ve included a description of Revenue Procedure, along with a prior relevant Revenue Procedure, below.
Revenue Procedure 2008-24 superseded Notice 2003-51 and gave additional guidance on what partial exchanges will be considered valid tax-free exchanges. It stated that a valid transfer would be one in which no distributions would be taken from either contract within a year of the exchange.
Rev. Proc. 2008-24 says that if a distribution is taken too soon, the whole Section 1035 transaction fails.
Here’s an example. Say the exchange outlined above takes place–$100,000 cash value contract, $50,000 basis, is split into two equal contracts. The taxpayer also makes a $10,000 withdrawal within 12 months of the split. Under Rev. Proc. 2008-24, if the $10,000 withdrawal is made within 12 months–and none of the life events apply–then the exchange is treated as invalid, and taxes and penalties would be due on the entire $50,000 gain.
Rev. Proc. 2011-38 changed the 2008 Procedure in the following ways:
1.The 12-month waiting period was shortened to 180 days.
2. The limitations upon withdrawals within 180 days no longer apply to partial annuitizations as long as the annuity period is for ten years of more, or is based upon the life of one or more persons.
3. Transfers failing to meet the 180 day waiting period will not automatically cause the partial exchange amount to be treated a taxable distribution under Code Section 72(e).
Revenue Procedure 2011-38 is effective for transfers taking place on or after October 24, 2011.
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