Cost basis is one of the most misunderstood aspects of a 1035 exchange. Getting it right determines whether your exchange is truly tax-free — and what your tax exposure will be if you ever surrender the new policy in the future.
What Is Cost Basis in a Life Insurance Policy?
Your cost basis in a life insurance policy is the total amount of after-tax premiums you have paid into the policy, minus any dividends received that were not reinvested and any tax-free withdrawals you have taken. It represents the amount you have already paid tax on — and therefore will not be taxed again.
The "gain" in a policy — the amount that would be taxable upon surrender — is the current cash value minus your cost basis.
How Cost Basis Transfers in a 1035 Exchange
When you execute a 1035 exchange, your entire cost basis from the old policy transfers to the new policy. The IRS treats the new policy as a continuation of the old one for tax purposes. This means:
The gain that existed in the old policy continues to be deferred in the new policy — it is not eliminated
If you surrender the new policy in the future, the taxable gain is calculated using the original cost basis from the old policy
The cost basis does NOT reset to the amount transferred — it carries over from the original policy
If the new policy's cash value grows beyond the transferred amount, the additional growth is also tax-deferred
The Impact of Policy Loans
If your existing whole life policy has an outstanding loan, the loan complicates the cost basis calculation. The IRS treats a policy loan as a reduction in the amount transferred, which can affect whether any portion of the exchange is taxable.
Specifically: if the loan balance plus any gain in the policy exceeds your cost basis, a portion of the exchange may be taxable. This is a nuanced calculation that requires careful analysis before proceeding with an exchange on a policy with outstanding loans.
Partial 1035 Exchanges
In a partial 1035 exchange, you transfer only a portion of the cash value from the old policy to a new policy. The IRS allocates the cost basis proportionally based on the percentage of cash value transferred.
For example: if you transfer 60% of the cash value, 60% of the cost basis transfers to the new policy. The remaining 40% of the cost basis stays with the original policy.
Important: This Is Not Tax Advice
Cost basis rules for life insurance exchanges are complex and fact-specific. The information in this article is for educational purposes only. Always consult a qualified tax professional before executing a 1035 exchange to understand the specific tax implications for your situation.