Cash value which is transferred from one life insurance policy to another without paying tax on the original contract. This kind of transaction is governed by Section 1035 of the Internal Revenue Service Code; hence its name.
The IRS allows you to exchange one life insurance policy you own for a new one. As long as the second policy costs the same amount or more than the first, a replacement transaction can be performed with no capital gains and/or losses paid on the first one.
There are a few conditions, however, for a 1035 Exchange:
- You can’t cash out the first policy, receive a check, and apply the proceeds to the purchase of the new policy.
- You can make a tax-free exchange from either one life insurance policy to another life policy, or a life insurance policy to an annuity-but you can’t exchange an annuity for a life insurance policy.
Possible reasons for replacing one life insurance policy with another may include improved health, better policy benefits or features, and poor customer service.