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Question: My client owns a permanent life policy with a loan against it. He wants to exchange the policy for a new, loan-free policy. Is that allowed?
Answer: Section 1035 of the Internal Revenue Code allows a taxpayer to exchange life policies for new ones without paying tax on the gain.
However, there are policy transfers which may not qualify as tax-free exchanges. One such transfer is the exchange of a life policy with an outstanding loan. Money or other property received as part of an exchange is known as “boot.”
If a policy, in which the owner has a gain, is exchanged for a new one and the loan on the old policy disappears as part of the transaction, the owner must recognize taxable boot. The boot is the lesser of the loan repaid or the gain in the policy.
In several private letter rulings, the IRS has held a policy may be exchanged tax-free for another policy, if the new policy is subject to the same amount of indebtedness as the old one.
If the new insurance company will not issue a policy with a loan against it the taxpayer has two options:
(1) pay off the loan on the old policy with funds from another source and then borrow on the new policy, if necessary; or
(2) exchange the policy, “bite the bullet” and pay the tax generated when the loan on the old policy is extinguished.
The IRS may find taxable boot in a step transaction. In Private Letter Ruling 9141025, a taxpayer owned a life insurance policy bought with a single premium of $1 million; there was a $448,000 outstanding loan on the policy. The taxpayer proposed to pay off the loan through a partial surrender (withdrawal) from the policy.
The taxpayer expected to treat the withdrawal as a tax-free return of premium. The plan was to then exchange the remaining cash value for a new policy and treat it as a 1035 exchange.
Smartly, the taxpayer asked the question before doing the act. IRS held the proposed transaction would cause taxable boot equal to the extinguished $448,000 loan; the policy withdrawal would not be an independent transaction but part of a step transaction.
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