A 1035 exchange opportunity many advisors don't know aboutArticle added by Jeff Reed on December 3, 2012
Jeff Reed

Jeff Reed

San Diego, CA

Joined: May 07, 2012

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There are a bunch of life policies out there with loans on them. These policies are frequently in danger of lapsing, and the likelihood of finding yourself with a client facing a very unwelcome surprise at tax time as a result of a poorly executed exchange is alarmingly high.

1035 exchange a policy with a loan balance — You can do that?

While it is commonplace for us, it was news to the producer I was speaking with, and it is an area that can trip you up in a very, very big way. How big? How about creating a taxable event for your client despite a 1035 exchange being executed? Did I mention that there are no actual dollars in your client's pocket as a result and they still may have to pay some tax? Do I have your attention? I think I should.

So, just how does this happen? It all comes down to the concept of "boot" and the creation of a situation where the exchange is no longer considered like to like. Of course, this assumes that there is gain in the contract, and that we elect to pay off the loan rather than move it over to the new policy. To make matters even more complicated, this same issue can rear its ugly head when we are doing something as simple as pulling money out of a contract prior to the exchange, even if there is no loan.

The technical details of all of this are beyond the scope of this forum, but can be found in these two publications: So, if we are not going to dive into the technical details, why bring up this topic today? One reason: There are a bunch of life policies out there with loans on them. These policies are frequently in danger of lapsing, and the likelihood of finding yourself with a client facing a very unwelcome surprise at tax time as a result of a poorly executed exchange is alarmingly high. You know as well as I do that if they are facing an unwelcome and unexpected tax bill, then it is a pretty short trip to the phone to call the agent that handled the transaction to demand answers.
Now that we all understand the problem, what is the solution? Step one is being aware of the trap, so we have that handled. Step two, however, is a bit more complicated. When we start talking tax code, 1035 exchanges and boot, we find ourselves squarely in the gray area of our business where the lines between being a life insurance professional and providing tax advice begin to blur. This is not something that we can afford to have happen. The downside is simply too enormous. We need a better strategy.

In the past, I've suggested that we change the way we do business (evolve even) if we want to remain effective. This time, we should do just the opposite and get back to one of the pillars of our past success: tapping our professional network. We all need CPAs and attorneys we can trust. We really need some who flat-out know life insurance taxation. If you have been in the business for long, you probably already know them.

It's time to dust off those relationships and start using them to set yourself apart from the rest of the pack. Your clients may never thank you for helping them avoid a problem the never knew they had, but the revenue from being able to rescue that old, over-loaned life contract can sure help you keep your practice in the black where it belongs. Knowing you did it right will help you sleep at night.
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