Which of the following exchanges qualifies for tax-free treatment under IRC §1035?
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Answer & full 3-part explanation (select an option above, or peek)
Why B is correct
IRC §1035 permits a tax-free exchange of a life insurance policy for another life insurance policy, a life insurance policy for an annuity, and an annuity for another annuity. The exchange must be direct between contracts and no cash may be taken out in the transaction. Exchanging an annuity for life insurance is not tax-free because it converts a tax-deferred asset into a different type of contract, so the gain would be recognized. Section 1035 preserves the policyowner's cost basis across the exchange, allowing the tax deferral to continue without interruption.
Why the other options are wrong
- A) Exchanging an annuity for a life insurance policy is not a permitted §1035 transaction, because the rule allows movement toward greater life coverage, not away from it. Such a swap would be treated as a taxable distribution of the annuity.
- C) A long-term care contract that is not life insurance does not qualify as a §1035 destination under the basic statutory rule. Only life, annuity, and certain endowment contracts are listed.
- D) A §1035 exchange must be direct between contracts; taking the funds personally first would trigger tax on the distribution. The direct transfer is essential to the deferral. The cash-out route forfeits the tax deferral.
Memory hook
§1035: life-to-life, life-to-annuity, annuity-to-annuity are free; annuity-to-life pays the taxman.