Tax implications of 1035 with loan

[loginname]

I think this information from the following website answers my question and the client would be taxed on $21,000. I am going to consult a CPA.

CNA Pro Agents/Registered Representatives

2. Cash or “Boot” Received by the Client. An exchange that otherwise qualifies for tax-free treatment under section 1035 may not be tax free to the extent the client receives cash or other “boot.” Boot means cash or other valuable non-qualifying property received in a section 1035 exchange. A problem can arise if the client receives cash (even temporarily) in connection with the surrender of the old contract. This trap (when recognized by a savvy agent) can be easily avoided by having the old contract’s cash surrender proceeds transferred directly by the old insurer to the new insurer to purchase the new contract. Another problem can arise if an outstanding loan encumbering the old contract is extinguished upon surrender of the old contract. The Internal Revenue Service (the “IRS”) has ruled that such an extinguished loan is treated as boot. Therefore, gain will be recognized by the client up to the amount of the extinguished loan less the amount of any loan encumbering the new contract. To avoid this trap, you may want to suggest to the client that either the loan should be repaid before the exchange or the new contract should be encumbered by a loan of an equal amount.

 

[arnguy]

I concur with the last post. How can anyone disagree with a couple of Philadelphia lawyers? Seriously, IMO the information is 100% correct. One cannot have possession of funds even for a nanosecond to qualify as a Sec. 1035 exchange. I have done a few of them, in each case the funds were exchanged between the insurance companies and were never in the possession of the insured.

The IRS interpretation of the extinguishing of the loan being deemed "booty" is quite logical even though the insured does not technically receive any funds.

 

[loginname]

They did receive funds when they took out the loan and extinguishing the loan with cash value during the 1035 exchange eliminates the need to ever pay it back.

 

[arnguy]

Well, of course they received the funds when they made the loan. However, because they did not extinguish the loan (according to your last post) prior to the 1035 exchange, but used the cash value in the policy at the time of the exchange, the payoff of the loan is considered booty. The cash value to payoff the loan has the same effect as if the client had received the cash (money) from the cash value and subsequently used it to payoff the loan, i.e., it becomes of the recognizable gain. Although the client did not receive the actual cash funds even momentarily, it is treated by the IRS as if they had actually received the money that was used to make loan repayment.

 

[loginname]

Agreed Arnguy. That's why I said there will be a taxable gain if the loan is extinguished during the 1035. It sounds like we are in agreement. I've run some more illustrations and it looks like it will work out fine to just transfer the loan during the 1035 thus avoiding any taxable situation.

 

[James]

Okay, the tax should be base the amount above the basis, last I look life insurance still goes by FIFO. Which would be $1,000 taxable, is this not correct?

 

[djs]

Okay, the tax should be base the amount above the basis, last I look life insurance still goes by FIFO. Which would be $1,000 taxable, is this not correct?

Only if you use the basis to pay off the loan, I believe. This is not necessarily the same thing. If the loan is unpaid and not transferred, then the full amount of the loan should be taxable, but the basis would still be intact.

I am not an expert in this area, but it makes sense. Unfortunately, tax laws don't always make sense.

Dan

 

[James]

Only if you use the basis to pay off the loan, I believe. This is not necessarily the same thing. If the loan is unpaid and not transferred, then the full amount of the loan should be taxable, but the basis would still be intact.

I am not an expert in this area, but it makes sense. Unfortunately, tax laws don't always make sense.

Dan

Okay I'll agree, yet if you are moving money from a WL to a SGUL type of policy you might as well use the basis. Not like you'll ever get cash or should get cash from a SGUL, NLPG type of plan.

 

[liveirisjul]

I think we may just transfer the loan with the 1035 and not have this tax problem...