1035 Exchange Cost Basis for Life Insurance Policies: What You Must Track

How Cost Basis Transfers in a 1035 Exchange

A 1035 exchange lets you surrender or cancel one life insurance policy and replace it with a new one without triggering immediate taxes. The cost basis from the original policy carries over to the new contract. That carryover is not automatic in the sense of being invisible; it becomes the new policy's cost basis for future gains calculations. If you surrender the new policy later, any amount received above that carried-over basis is generally taxable as ordinary income, not a capital gain.

Because the basis carries forward rather than resetting, errors in tracking can create a larger taxable event later. The original cost basis includes premiums paid minus any withdrawals or dividends retained within the contract that were not taxed when withdrawn.

What Constitutes Cost Basis in a Life Insurance Policy

The starting point for cost basis is the total premiums you have paid into the policy, reduced by certain adjustments:

• Premiums paid out of pocket for the policy
• Any dividends you chose to take in cash rather than reinvest
• Prior withdrawals that were not taxable because they did not exceed your basis

Adjustments that reduce basis include premium refunds and certain policy loans that were structured as partial surrenders. The basis does not include the cash value itself as a separate number; the cash value is the result of premiums invested and interest credited, and your gain is the difference between what you receive and the basis.

Why the Carried-Over Basis Matters After the Exchange

When the new policy is issued, the insurance company will typically record the basis from the old contract on the exchange paperwork. That number becomes the reference point for the new policy's gain or loss if it is surrendered or matured. If the new policy's cash value at surrender is higher than the carried-over basis, the difference is taxable income in the year of surrender.

The carryover also affects the holding period. A 1035 exchange does not reset the clock on long-term versus short-term treatment; the holding period of the original policy generally continues into the new one for tax purposes.

Common Mistakes That Distort Cost Basis Tracking

Several missteps can leave you with an incorrect basis figure after a 1035 exchange:

• Failing to include the basis from an annuity exchange that funded part of the new policy
• Accepting the new contract's stated cash value as the basis, which is wrong
• Ignoring prior 1035 exchanges that already shifted basis from an even older policy
• Not documenting dividends used to pay premiums, which can alter the net basis

Insurance companies may not remind you of prior basis figures, so maintaining your own records is essential. Request a written basis statement from the old carrier and keep it with the new policy's documents.

Interaction With Partial Surrenders and Loans After Exchange

Once the new policy is in force, any partial surrenders reduce your remaining basis on a last-in, first-out basis under current rules, unless the contract is an annuity where the order depends on how withdrawals are treated. Policy loans that are not repaid are generally treated as partial surrenders and can reduce basis as well. Each of these actions narrows the tax-free portion of any future distribution.

When the New Policy Is a Hybrid or Annuity Rider

Modern life insurance policies often include living benefit riders or are structured as life-with-annuity riders. In a 1035 exchange, the basis is typically allocated between the life and the annuity components based on the exchange value assigned to each. If the new contract holds both types of values, you may need to track two separate bases. When distributions begin from the annuity portion, the taxable part is determined by that allocated basis, not the overall basis of the contract.

Documentation You Should Keep

To protect yourself in a future audit, maintain the following:

• The basis statement from the surrendered policy
• The 1035 exchange request form or acknowledgment from the new carrier
• Records of any premiums paid on the new policy
• A running log of surrenders, withdrawals, and loans against the new policy

The IRS treats a 1035 exchange as a continuous transaction, so the chain of basis from the original contract forward must be clear and traceable.