A 1035 exchange is a tax-free swap of one insurance contract for another like-kind contract under Section 1035 of the Internal Revenue Code, letting an owner move the cash value of a life insurance policy or annuity into a new one without recognizing gain. It is a direct carrier-to-carrier transfer, and the built-up gain keeps deferring instead of becoming taxable income.
Under IRC Section 1035(a), no gain or loss is recognized when a qualifying life insurance, endowment, annuity, or qualified long-term care contract is exchanged for another like-kind contract (Source: 26 U.S.C. Sec. 1035(a)). The insurer reports the tax-free exchange on Form 1099-R using distribution code 6 in box 7 (Source: IRS Instructions for Forms 1099-R and 5498, 2026).
What is a 1035 exchange?
A 1035 exchange is a provision in the tax code that allows the owner of certain insurance contracts to exchange one for another without triggering a taxable event. The statute states plainly that “no gain or loss shall be recognized on the exchange” of qualifying contracts (Source: 26 U.S.C. Sec. 1035(a)). The accumulated gain inside the old contract is not erased; it carries forward and stays tax-deferred inside the new one.
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The concept mirrors the more familiar 1031 exchange for real estate, but it applies to insurance and annuity contracts rather than property. Section 1035 even borrows its basis rules directly from Section 1031 (Source: 26 U.S.C. Sec. 1035(d)(2)).
The exchange must be “like-kind,” a term with a specific meaning here. It does not mean identical; it means the contracts must fall within the pairings Congress authorized, which follow a strict one-way ladder explained below.
What contracts qualify: the like-kind requirement
Section 1035 permits only specific pairings of insurance and annuity contracts, and the direction of the exchange matters. A life insurance contract can move “down” the ladder into an annuity, but an annuity can never move “up” into life insurance. The permitted pairings are set out in Section 1035(a)(1) through (a)(4) (Source: 26 U.S.C. Sec. 1035(a)).
The table below shows what can be exchanged for what. Language in the IRS Instructions for Forms 1099-R and 5498 (2026) matches the statute exactly.
| Old contract | Can be exchanged tax-free for |
|---|---|
| Life insurance | Another life insurance policy, an endowment contract, an annuity, or a qualified long-term care (QLTC) contract |
| Endowment | Another endowment (payments beginning no later than under the old one), an annuity, or a QLTC contract |
| Annuity | Another annuity, or a QLTC contract only. Never life insurance. |
| Qualified long-term care (QLTC) | Another QLTC contract only |
The directional rule catches many people off guard. Because an annuity has no death benefit underwriting in the way life insurance does, Congress allowed life-to-annuity conversions but blocked annuity-to-life conversions (Source: 26 U.S.C. Sec. 1035(a)(3)). Section 1035 nonrecognition applies to contracts that carry accumulated value, so a policy with no cash value has no gain to defer and nothing to transfer (Source: 26 U.S.C. Sec. 1035(a)).
Section 1035 covers only nonqualified money, meaning contracts held outside a tax-advantaged retirement account. Moves between IRAs or employer plans use trustee-to-trustee transfer and rollover rules instead, not Section 1035. Investors weighing tax-deferred strategies sometimes also compare this with a Roth conversion, which is a different transaction with different rules.
Long-term care exchanges under the Pension Protection Act
Since 2010, an annuity or life insurance contract can be exchanged tax-free for a qualified long-term care insurance contract, a change enacted by Section 844 of the Pension Protection Act of 2006 and effective for exchanges after December 31, 2009 (Source: Pension Protection Act of 2006, Pub. L. 109-280, Sec. 844; IRS Notice 2011-68). The statute confirms life, endowment, and annuity contracts may all be exchanged for a QLTC contract, and that a QLTC rider does not disqualify the base contract (Source: 26 U.S.C. Sec. 1035(a), Sec. 1035(b)(3)).
This mechanic is one most explainer articles list but rarely detail. The tax appeal is specific: gain locked inside a low-basis annuity, which would otherwise come out as ordinary income, can instead fund tax-free long-term care coverage. The one-way rule still governs, though. A QLTC contract can only be exchanged for another QLTC contract, never back into an annuity or life policy.
How a 1035 exchange works
A 1035 exchange works as a direct transfer between insurance carriers. The policyholder never takes possession of the cash value; the funds move from the old insurer to the new insurer by assignment. If the owner instead receives a check, even one endorsed over to the second company, the transaction is treated as a taxable distribution rather than a tax-free exchange.
The IRS made this point directly in Rev. Rul. 2007-24, holding that a taxpayer’s receipt of a check from the first insurer, even when endorsed over to buy a new annuity, is a taxable distribution under Section 72(e) and not a tax-free Section 1035(a)(3) exchange (Source: Rev. Rul. 2007-24, 2007-21 I.R.B. 1282). Constructive receipt of the funds defeats the whole exchange.
The general process runs as follows:
- Confirm the new contract and the pairing are permitted under the like-kind ladder, and that the owner, insured, and annuitant will stay the same.
- Apply for and, where required, get underwriting approval on the new contract from the receiving insurer.
- Complete the receiving insurer’s 1035 exchange and absolute assignment forms, plus any state replacement disclosure forms.
- The receiving insurer sends the paperwork to the current carrier and requests a direct transfer of cash value.
- The current carrier surrenders the old contract and remits the value directly to the new insurer. No check is issued to the owner.
- The receiving insurer issues the new contract and applies the transferred value.
Throughout, the owner, insured, and annuitant on the new contract must match the old one. This is a common reason exchanges fail. Changing the beneficiary, by contrast, is permitted; the beneficiary is not one of the parties that must remain constant.
Owner, basis, and cost-basis carryover with a worked example
The cost basis of the old contract carries over to the new one in a 1035 exchange, which preserves the tax treatment of any future withdrawal. Section 1035 borrows this rule from Section 1031(d): the basis of the property received “shall be the same as that of the property exchanged,” adjusted for any money or gain recognized (Source: 26 U.S.C. Sec. 1035(d)(2); 26 U.S.C. Sec. 1031(d)).
Because most top explainers on this topic use zero dollar figures, here is a worked example. Assume an owner holds a nonqualified deferred annuity worth $150,000 with a cost basis of $90,000, meaning $60,000 of untaxed gain sits inside it. In a clean 1035 exchange into a new annuity, no tax is due, and the new contract starts with the same $90,000 basis and $60,000 of embedded gain. Had the owner instead surrendered the old annuity for cash, that $60,000 would be taxable as ordinary income, not capital gains, and, if the owner were under age 59 and a half, a 10% additional tax could apply to the taxable portion (Source: 26 U.S.C. Sec. 1035(a); IRS Topic No. 558).
Boot changes the math. If the owner receives any cash or non-like property in the exchange, gain is recognized to the extent of that boot, and the carried-over basis is reduced accordingly (Source: 26 U.S.C. Sec. 1035(d)(1); 26 U.S.C. Sec. 1031(d)). Relief of a policy loan is generally treated the same way, as money received, which is why outstanding loans complicate an exchange.
Outstanding policy loans
An outstanding loan against a life insurance policy can turn part of a 1035 exchange into a taxable event or disqualify it. Loan relief is generally treated as money received, or boot, under the Section 1031(b) and (d) mechanics that Section 1035 applies (Source: 26 U.S.C. Sec. 1035(d)(1); 26 U.S.C. Sec. 1031(d)). One common approach is to repay the loan before the exchange so the full cash value transfers cleanly, though repayment has its own cost and cash-flow effects.
The partial 1035 exchange and the 180-day trap
A partial 1035 exchange lets an owner move only part of an annuity’s cash value into a second annuity tax-free, but a withdrawal made too soon can retroactively taint the transaction. Under Rev. Proc. 2011-38, a direct transfer of part of an annuity’s value into a second annuity qualifies as a tax-free Section 1035 exchange, provided no amount is received under either contract during the 180-day period beginning on the transfer date (Source: Rev. Proc. 2011-38, Sec. 4.01).
This safe harbor is where partial exchanges go wrong. If money is pulled from either the old or the new annuity inside that 180-day window, the IRS can recharacterize the arrangement and treat it as a taxable distribution rather than a tax-free exchange. The rule took effect for transfers completed on or after October 24, 2011 (Source: Rev. Proc. 2011-38, 2011-30 I.R.B. 66).
There is a carve-out. Payments received as an annuity for a period of 10 years or more, or over one or more lives, do not break the safe harbor (Source: Rev. Proc. 2011-38, 2011-30 I.R.B. 66, Sec. 4.01). Retirees coordinating income timing across several accounts sometimes review this alongside their required minimum distributions so that a needed withdrawal does not accidentally fall inside the window.
MEC status and life insurance clauses that carry over
A Modified Endowment Contract (MEC) keeps its MEC status through a 1035 exchange, a “once a MEC, always a MEC” carryover that surprises many owners. Section 7702A(a)(2) defines a MEC to include a contract “received in exchange for” a MEC, so exchanging a MEC life insurance policy for a new one carries the taint forward (Source: 26 U.S.C. Sec. 7702A(a)).
MEC status matters because it changes how withdrawals and loans are taxed: distributions from a MEC are taxed on a gain-first (last-in, first-out) basis as ordinary income under Section 72(e)(10), and the taxable portion of a distribution taken before age 59 and a half generally carries a 10% additional tax under Section 72(v), unlike a non-MEC life policy (Source: 26 U.S.C. Sec. 72(e); 26 U.S.C. Sec. 72(v)). A 1035 exchange cannot wash out that classification.
Two protective clocks also generally restart on a new life insurance policy because the replacement is a newly issued contract. As a result, the two-year contestability period and the suicide clause typically begin again on the new policy (Source: FINRA, “Should You Exchange Your Life Insurance Policy?”). During the contestability window, the insurer retains broader rights to challenge the policy.
Pros and cons of a 1035 exchange
A 1035 exchange can preserve tax deferral and basis while giving access to a newer contract, but it can also reset surrender charges and add new costs. The right balance depends entirely on the specific old and new contracts and the owner’s circumstances. The table below summarizes the trade-offs neutrally.
| Potential advantages | Potential drawbacks |
|---|---|
| Gain stays tax-deferred instead of becoming taxable ordinary income (Source: 26 U.S.C. Sec. 1035(a)) | Surrender charges may apply to the old contract; some may be a flat fee, others a percentage |
| Cost basis carries over to the new contract (Source: 26 U.S.C. Sec. 1031(d)) | A new surrender-charge period often restarts on the replacement contract |
| Access to lower-fee features, new riders, or a higher death benefit | New sales charges, mortality and expense (M&E) fees, and commissions may apply |
| Can fund qualified long-term care coverage from an annuity’s gain (Source: 26 U.S.C. Sec. 1035(a)) | Age or health may make a new contract more expensive or unavailable |
| Beneficiary can be updated on the new contract | MEC status carries over (Source: 26 U.S.C. Sec. 7702A) and contestability and suicide clauses can restart on the new policy (Source: FINRA) |
When a 1035 exchange may make sense, and when it may not
A 1035 exchange may make sense when a newer contract offers materially lower costs, features the old one lacks, or a shift such as moving from a variable annuity to a fixed annuity, and when surrender charges on the old contract are low or no longer apply. It may be less attractive when a fresh surrender period, new commissions, or reduced access to funds offset the benefit.
Age or health can also make a replacement contract more costly or unavailable. These are neutral considerations, not recommendations, and the analysis depends on individual facts.
Tax reporting for a 1035 exchange
A tax-free 1035 exchange is still reported to the IRS, even though no tax is due. The insurer files Form 1099-R with distribution code 6 in box 7. For a reportable exchange, the insurer enters the total contract value in box 1, zero in box 2a for the taxable amount, and total premiums paid in box 5 (Source: IRS Instructions for Forms 1099-R and 5498, 2026).
Reporting practice can vary by fact pattern. The IRS instructions direct insurers to report a Section 1035 exchange on Form 1099-R, and the presence of a zero taxable amount in box 2a confirms the exchange qualified rather than signaling tax owed (Source: IRS Instructions for Forms 1099-R and 5498, 2026). Owners should confirm how a given carrier reports the transaction.
Owners coordinating a year’s tax picture sometimes look at how an exchange interacts with thresholds like the net investment income tax or Medicare IRMAA surcharges, since a busted exchange that becomes taxable can push income higher.
Suitability, replacement rules, and the best-interest context
Because a 1035 exchange replaces one contract with another, it sits inside a set of suitability and disclosure requirements. For recommendations involving deferred variable annuities, FINRA Rule 2330 imposes suitability and principal-review obligations on the recommending firm, including surveillance of exchange activity (Source: FINRA Rule 2330). Replacements also carry state-level disclosure duties.
For life insurance and annuity replacements, the NAIC model regulation calls for a replacement disclosure notice given to the applicant at the time of application (Source: NAIC Life Insurance and Annuities Replacement Model Regulation, Model #613). Separately, all 50 states have adopted the NAIC best-interest revisions to the annuity suitability model, with adoption completed in 2025 (Source: NAIC Suitability in Annuity Transactions Model Regulation, Model #275).
These requirements exist because a replacement can benefit the seller through new commissions even when the benefit to the owner is less clear. Reviewing the replacement form line by line, and comparing surrender charges, fees, and features, is one way owners assess whether an exchange serves their goals. Speaking with an independent professional who does not earn a commission on the new contract is another approach.
Work with Q3 Advisors
Q3 Advisors is a registered investment adviser focused on retirement tax planning. This article is educational and is not advice; for guidance on your own circumstances, consult a qualified tax or financial professional.
Frequently asked questions
How does a 1035 exchange work?
A 1035 exchange works as a direct transfer between insurance carriers in which the owner never receives the cash value. The new insurer requests the funds from the old one, the old contract is surrendered, and the value is applied to the new contract with no tax due on the gain (Source: 26 U.S.C. Sec. 1035(a)). Receiving a check, even one endorsed over, makes it taxable (Source: Rev. Rul. 2007-24).
What is not allowed in a 1035 exchange?
Exchanging an annuity for a life insurance policy is not allowed; the ladder is one-way (Source: 26 U.S.C. Sec. 1035(a)(3)). Term life insurance does not qualify because it has no cash value. IRAs and employer plan assets do not use Section 1035. Taking constructive receipt of the cash defeats the exchange (Source: Rev. Rul. 2007-24), and the owner, insured, and annuitant must stay the same.
Can you 1035 exchange an annuity to life insurance?
No. An annuity cannot be exchanged tax-free for a life insurance policy. Section 1035(a)(3) permits an annuity to be exchanged only for another annuity or a qualified long-term care contract (Source: 26 U.S.C. Sec. 1035(a)(3)). Life insurance can move “down” into an annuity, but an annuity cannot move “up” into life insurance. This directional rule is a frequent point of confusion.
Does a 1035 exchange reset the contestability and suicide clause periods?
Generally yes for life insurance. Because a 1035 exchange results in a newly issued replacement policy, the two-year contestability period and the suicide clause typically begin again on the new contract (Source: FINRA, “Should You Exchange Your Life Insurance Policy?”). During the contestability window the insurer retains broader rights to challenge the policy. This is an important protection present in an older policy that a new one may not immediately carry.
Are there deadlines for completing a 1035 exchange?
A full exchange has no fixed statutory deadline, but partial annuity exchanges carry a 180-day rule. Under Rev. Proc. 2011-38, no amount may be received under either the old or new annuity during the 180-day period beginning on the transfer date, or the exchange can be recharacterized as taxable (Source: Rev. Proc. 2011-38, 2011-30 I.R.B. 66). Certain long-term annuity payments are excepted.
Do you have to report a 1035 exchange on your taxes?
Usually yes, even though no tax is due. The insurer files Form 1099-R with distribution code 6 in box 7 and enters zero as the taxable amount in box 2a (Source: IRS Instructions for Forms 1099-R and 5498, 2026). Reporting practice can vary by fact pattern, so owners should confirm how a given carrier reports the transaction.
Can you do a partial 1035 exchange?
Yes. Rev. Proc. 2011-38 allows a direct transfer of part of an annuity’s cash value into a second annuity as a tax-free exchange, as long as no amount is received under either contract during the 180-day period after the transfer (Source: Rev. Proc. 2011-38, 2011-30 I.R.B. 66). A withdrawal inside that window can taint the exchange retroactively.
Does a term life insurance policy qualify for a 1035 exchange?
No. Term life insurance does not qualify as the contract being exchanged because it has no cash value to carry over. Section 1035 nonrecognition applies to contracts with accumulated value, such as permanent life insurance, endowments, and annuities (Source: 26 U.S.C. Sec. 1035(a)). Without cash value, there is no gain to defer and nothing to transfer.
What are the disadvantages of a 1035 exchange?
Potential disadvantages include surrender charges on the old contract, a restarted surrender period on the new one, new sales charges, mortality and expense fees, and commissions, and higher cost or ineligibility due to age or health (Source: FINRA Rule 2330; FINRA, “Should You Exchange Your Life Insurance Policy?”). For life insurance, MEC status carries over (Source: 26 U.S.C. Sec. 7702A) and the contestability and suicide clauses can restart on the new policy. Whether these outweigh the benefits depends on the specific contracts.
Does a 1035 exchange affect MEC status?
Yes. Modified Endowment Contract status carries over. Section 7702A(a)(2) defines a MEC to include a contract received in exchange for a MEC, so a MEC exchanged for a new life insurance policy keeps its MEC classification (Source: 26 U.S.C. Sec. 7702A(a)). Distributions from a MEC are taxed gain-first as ordinary income under Section 72(e), and an exchange cannot remove that treatment (Source: 26 U.S.C. Sec. 72(e)).
Sources
26 U.S.C. Sec. 1035 (Certain exchanges of insurance policies), https://www.law.cornell.edu/uscode/text/26/1035
26 U.S.C. Sec. 1031(d) (basis of property acquired in exchange), https://www.law.cornell.edu/uscode/text/26/1031
26 U.S.C. Sec. 7702A (Modified endowment contracts), https://www.law.cornell.edu/uscode/text/26/7702A
26 U.S.C. Sec. 72 (Annuities; certain proceeds; gain-first and additional-tax rules at Sec. 72(e) and (v)), https://www.law.cornell.edu/uscode/text/26/72
Pension Protection Act of 2006, Pub. L. 109-280, Sec. 844 (long-term care exchange provision), https://www.congress.gov/bill/109th-congress/house-bill/4
IRS Notice 2011-68 (long-term care insurance under Sec. 1035), https://www.irs.gov/pub/irs-drop/n-11-68.pdf
FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities), https://www.finra.org/rules-guidance/rulebooks/finra-rules/2330
FINRA, Should You Exchange Your Life Insurance Policy?, https://www.finra.org/investors/insights/should-you-exchange-your-life-insurance-policy
NAIC Life Insurance and Annuities Replacement Model Regulation (Model #613), https://content.naic.org/sites/default/files/model-law-613.pdf
NAIC Suitability in Annuity Transactions Model Regulation (Model #275), https://content.naic.org/sites/default/files/model-law-275.pdf
IRS Instructions for Forms 1099-R and 5498 (2026), https://www.irs.gov/instructions/i1099r
Rev. Rul. 2007-24, 2007-21 I.R.B. 1282, https://www.irs.gov/irb/2007-21_IRB
Rev. Proc. 2011-38, 2011-30 I.R.B. 66, https://www.irs.gov/irb/2011-30_IRB
IRS Topic No. 558 (Additional tax on early distributions), https://www.irs.gov/taxtopics/tc558
IRS Publication 575 (2025), https://www.irs.gov/publications/p575
