Advanced Underwriting Consultants

Question of the Day – May 4

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 owns a whole life policy with $5,000 of surrender value, and with a $100,000 outstanding loan.  The client’s basis in the policy is $50,000.  The policy will crash soon, and the client is interested in exchanging the policy under Section 1035 to new universal life coverage.  What are the tax consequences of the exchange?

Answer: The IRS has ruled that if a loan disappears as part of a Section 1035 exchange, the loan is treated as taxable boot.  That means that the loan forgiven during the exchange process will be taxed on a gain-first basis.  If the policyowner’s basis is contract is $50,000 and the gross cash value—loan plus surrender value—is $105,000, the gain is $55,000.

Since the loan forgiven in this example would be more than $55,000, the whole $55,000 gain would be taxable income to the client.  The rest of the loan balance forgiven–$45,000—would reduce the policyowner’s basis.

The $5,000 net surrender value would be exchanged into the new policy, and the policyowner’s basis in the new contract would likewise be $5,000–$50,000 original basis minus $45,000 non-taxable portion of loan balance forgiven.


In some private letter rulings from the 1980’s, the IRS approved the exchange of a policy with an existing loan for a new policy with a loan at least as big as the old one.  In those cases, the Service said there was no taxable boot.

However, there are two practical problems with trying to exchange one policy subject to a loan for a new one subject to a loan:

  1. Relatively few life carriers will allow a policy to be issued with an immediate loan balance
  2. Carrying over a loan doesn’t help much for the long-term viability of the policy

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.