Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client is seeking to do a Section 1035 exchange of a life insurance policy for a new one.  The existing policy has a substantial surrender charge.  If the client does the exchange, is the surrender charge tax deductible?

Answer: No.

If a taxpayer does a 1035 exchange, the basis from the existing policy is carried over to the new one.  No gain or deductible loss is recognized.

On the other hand, if a life insurance policy is surrendered in a loss position, the loss may be deductible by the taxpayer.  A loss deduction can be claimed only upon the contract’s full surrender, and only if the loss is incurred in connection with the taxpayer’s trade or business or in a transaction entered into for profit.  See Revenue Code Section 165.

Courts have been inconsistent how to decide when an individual taxpayer is considered to have purchased a life policy for profit.  Even where the policy is purchased for profit, the individual’s ability to deduct a loss is restricted to those who itemize and who meet the miscellaneous expense deduction 2% of AGI floor.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.