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Swap financial products of different stripes

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in Small Business Tax,Small Business Tax Deduction Strategies

As you’re probably well aware, you can swap one real estate property for another real estate property without paying any current federal income tax, as long you meet the requirements under Section 1031 of the tax code. Similarly, many people already know that you can use the same technique to swap one life insurance policy tax-free for a comparable policy under Section 1035 of the tax code.

But do you know that this tax law provision may also apply to different types of financial products?

Strategy: Swap a life insurance policy for an annuity if you don’t need the policy and the surrender value is lower than the premiums you’ve paid. Then you can use the loss from the policy to offset taxable gains from the annuity.

Note that this strategy won’t work with term insurance. It only applies to life insurance policies with a cash value like a whole life or universal policy.

Here’s the whole story: If you bought a cash value life insurance policy years ago and the kids are out of the house, you may not have the same coverage needs anymore. Or maybe other circumstances dictate that you should give up the policy.

If the policy’s cash value (its “surrender value”) is less than the total premiums paid into the policy, you can’t deduct the loss or use it to offset capital gains in other investments. However, when you transfer the cash value to an annuity, the loss may be used to offset subsequent gains in the annuity.

Example: Suppose that you have paid $100,000 into a life insurance policy over time, but its surrender value is only $60,000 due to investment losses, expenses and surrender charges. If you use the $60,000 to purchase an annuity, the account will have a value of $60,000, but its basis for determining gain or loss remains $100,000 (i.e., the original cost of the investment).  

As a result, you can use the $40,000 loss derived from the tax-free switch to offset capital gains from the annuity. You can also add more cash to the annuity, which will enable you to harvest your loss even faster, because it will take less time to generate gains.

On the other side of the coin, any gains realized in this type of Section 1035 exchange are deferred, just like the more common example involving a swap of real estate properties.

The life insurance policy-for-annuity swap doesn’t get nearly the same attention as other types of tax-free exchanges, mainly because insurance agents usually won’t tout this option.  This may be due to the financial incentives for the agent or because a new policy will appear to be less expensive if it starts out with money from the old policy.

But you should consider the alternative of switching to an annuity. If you want more cash value life insurance, you can still acquire it with separate funds.

To benefit from a Section 1035 exchange of these financial products, the life insurance policy must have a positive cash value. If it doesn’t and the policy is essentially “underwater,” which could occur in a policy’s early years because of high expenses, you might ask the insurer to waive a small portion of the surrender charge. This preserves your ability to transfer the basis and the tax benefits.

Look to move the cash into no-load annuities from reputable firms like Fidelity, Vanguard and TIAA-CREF. Be sure to verify the basis amount with the annuity provider.

Tip: You can’t simply cash out the annuity right away and claim a loss. (Unlike insurance policies, losses from an annuity are tax-deductible.) The IRS will likely argue that this is a disguised method of converting a nondeductible loss into a deductible one.

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