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?
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.
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