What Can You Exchange Tax-Free in a 1035 Exchange? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 and the 2026 filing season. State insurance and tax rules vary — confirm current figures with your state before you act. This guide is educational and is not a substitute for advice from a licensed CPA, tax attorney, or insurance professional for your specific situation.

Quick Answer

A 1035 exchange lets you swap one insurance-based contract for another similar one without paying tax on the gain. For 2025–2026, you can tax-free exchange life insurance, endowment, annuity, and qualified long-term care contracts — but only in the directions the IRS allows under Internal Revenue Code Section 1035.

A 1035 exchange solves a real money trap: you own an old annuity or life policy with built-in gains, and cashing it out would trigger ordinary income tax on every dollar of growth. By swapping instead of surrendering, you move that gain — and your original cost basis — into a better contract and keep the tax bill at zero for now.

The stakes are bigger than most people think. Americans held over $2.5 trillion in annuity reserves heading into 2025, and a single wrong move — naming a new owner, taking cash “boot,” or exchanging in the wrong direction — converts a tax-free transfer into a fully taxable event in the year you do it.

🔄 The exact swaps Section 1035 allows — and the ones it silently forbids.
💵 How your cost basis carries over so you do not lose your tax shelter.
⚠️ Why touching the cash yourself blows up the whole exchange.
🏥 How an old annuity or life policy can fund long-term care tax-free.
📋 The forms, deadlines, and 1099-R surprises that trip people up.

What a 1035 Exchange Actually Is

A 1035 exchange is a tax rule, not a product. It comes from Section 1035 of the tax code, and it says no gain or loss is recognized when you trade one qualifying insurance contract directly for another qualifying contract. Recognized simply means “counted as taxable income this year.” The gain does not vanish — it rides along inside the new contract until you actually pull money out later.

Think of it like rolling one retirement account into another. The dollars never land in your checking account, so the IRS does not treat the move as a payout. Your money stays inside the insurance “wrapper” the whole time, which is the entire point.

This matters because annuities and cash-value life insurance grow tax-deferred. When you surrender one for cash, the growth above what you paid in becomes ordinary income — taxed at rates up to 37% for 2025. A 1035 exchange is the legal escape hatch that lets you upgrade to a cheaper, stronger, or more suitable contract without handing the IRS a slice on the way.

The rule sits beside its better-known cousin, the Section 1031 like-kind exchange for real estate. They share DNA — both defer gain on a swap — but 1035 covers only insurance contracts and has no 45-day or 180-day clock. The consequence of confusing the two is real: a 1031 has strict deadlines, while a 1035 fails for entirely different reasons, mostly tied to who owns and who touches the money.

What You Can Exchange Tax-Free

Section 1035 lays out a one-way street. Some contracts can flow “downhill” into others, but never back up. The table below shows every allowed direction for 2025–2026, drawn straight from the statute’s general rules.

The single biggest mistake is assuming any insurance contract can become any other. It cannot. The direction of the swap is what makes or breaks the tax-free status, and the consequence of going the wrong way is full taxation of your gain in the year you do it.

Contract You Currently Own	Tax-Free New Contract It Can Become
Life insurance	Life insurance, endowment, annuity, or qualified long-term care
Endowment	Another endowment, annuity, or qualified long-term care
Annuity	Another annuity or qualified long-term care
Qualified long-term care	Another qualified long-term care

Notice the pattern. As you move down the list, your options shrink. Life insurance is the most flexible starting point, and a qualified long-term care (LTC) contract is the most limited — it can only become another LTC contract.

Life Insurance Exchanges

A life insurance policy is the most flexible contract you can own for 1035 purposes. Under the statute, you can exchange it tax-free for another life policy, an endowment, an annuity, or a qualified LTC contract. This is the widest set of exits in the whole rule.

People use this most often to escape an old, expensive whole-life or universal-life policy. Maybe the premiums climbed, the insurer’s ratings dropped, or your health improved and you can do better elsewhere. Swapping into a newer policy keeps your cost basis and your tax deferral intact.

The catch is that you can go down the ladder but never up. The consequence of trying to turn an annuity back into life insurance is a fully taxable event. What you should do: confirm the insured stays the same person, because changing the insured on a life policy generally breaks the exchange and triggers tax.

Annuity Exchanges

An annuity is the most common starting point for a 1035 exchange. You can swap it tax-free for another annuity or for a qualified LTC contract — and that is the entire list. You cannot turn an annuity into life insurance, no matter how the agent pitches it.

The reason is policy design. Annuity gains are eventually taxed as ordinary income, while life insurance death benefits pass income-tax-free. Congress refused to let people launder annuity gains into a tax-free death benefit, so that door stays locked.

The most common real use is dumping a high-fee variable annuity for a low-fee one, or moving to an annuity with a better income rider. The consequence of ignoring direction here is severe: an attempted annuity-to-life swap is treated as a surrender, and the full gain hits your return that year. What you should do: ask the new insurer to handle it as a direct insurer-to-insurer transfer so you never receive the money.

Long-Term Care Exchanges

Since 2010, you can exchange a life insurance policy or an annuity into a qualified long-term care insurance contract tax-free, thanks to the Pension Protection Act of 2006 (effective for exchanges after December 31, 2009). This is one of the most valuable and underused moves in the entire rule.

Here is why it is powerful. An old annuity with a large taxable gain can be converted, dollar by dollar, into LTC coverage — and those LTC benefit payments come out tax-free. You essentially turn a future tax bill into tax-free care funding.

A qualified LTC contract, however, is a dead end for exchanges. It can only become another qualified LTC contract — never an annuity or life policy. The consequence of expecting to “undo” an LTC exchange is that you simply cannot without surrendering and paying tax. What you should do: only exchange into LTC the amount you are confident you want committed to care, since the move is hard to reverse.

What You Cannot Exchange (the Forbidden Swaps)

The fastest way to owe a surprise tax bill is to attempt a swap the code does not allow. These are the moves that look reasonable but are not tax-free.

Annuity → life insurance. Banned outright. The gain becomes taxable income this year.
LTC → annuity or life insurance. Not permitted; LTC only flows to LTC.
A Roth IRA, 401(k), or IRA → annuity as a “1035.” Wrong rule — retirement accounts move by rollover under different sections, not 1035.
Changing the owner mid-swap. The owner on the old and new contract must match, or the exchange fails.
Different insured on a life policy. Generally breaks tax-free treatment.

The consequence in every case above is identical: the IRS treats the transaction as a surrender, and any gain above your cost basis is taxed as ordinary income, plus a possible 10% early-distribution penalty if you are under 59½ on an annuity. What you should do: run any planned swap past the receiving insurer’s 1035 desk before signing, because they confirm whether the direction is legal.

Which Situation Applies to You?

The right answer depends on what you own and why you want out. Use this quick branch to find your path.

You own a pricey annuity and want lower fees or a better income rider. Your move is an annuity-to-annuity 1035. Read the Annuity Exchanges and Partial Exchanges sections.
You own old cash-value life insurance you no longer need. You have the most options — life, endowment, annuity, or LTC. Read Life Insurance Exchanges.
You are worried about future nursing-home or home-care costs. Look hard at an annuity-or-life-to-LTC exchange. Read Long-Term Care Exchanges.
You inherited a contract or want to change the owner. Stop. An ownership change usually breaks the exchange. Read Mistakes to Avoid and call a professional first.
You want to move only part of a contract. You need a partial 1035. Read Partial Exchanges and Cost Basis carefully.

How Cost Basis Carries Over

Cost basis is simply the total amount you paid into the contract — your premiums or deposits, minus any prior withdrawals. In a 1035 exchange, your basis carries over to the new contract unchanged, under the rules cross-referenced from Section 1031(d). This is what preserves your tax position.

Here is why it matters. If you paid $50,000 into an annuity now worth $80,000, your basis is $50,000 and your gain is $30,000. After a clean 1035 exchange, the new annuity still shows a $50,000 basis and a $30,000 embedded gain. Nothing was taxed, and your future taxable amount is exactly the same as before.

The consequence of getting basis wrong shows up years later, when you finally take income and the insurer reports the taxable portion. A common misconception is that a 1035 “resets” basis to the new contract’s full value — it does not. What you should do: keep every statement from the old contract proving what you paid, because the new insurer may not have that history and you will need it to defend the basis.

A Worked Example: Annuity-to-Annuity Swap

Maria, age 62, owns a variable annuity she funded with $100,000 over the years. It is now worth $140,000 but charges 2.3% in annual fees. She wants a low-cost annuity charging 0.6%.

If Maria surrenders for cash, she owes ordinary income tax on the $40,000 gain. At a 24% federal rate for 2025, that is $9,600 in tax — and because she is under 59½… wait, she is 62, so no 10% penalty applies, but the $9,600 still stings.

If Maria does a 1035 exchange instead, she moves the full $140,000 directly to the new insurer. She pays $0 tax today. Her basis stays $100,000, her embedded gain stays $40,000, and she now saves roughly $2,380 a year in fees on a $140,000 balance. The exchange turned a $9,600 tax hit into zero.

Partial Exchanges and Cost Basis

The IRS allows a partial 1035 exchange, where you move only part of one annuity into a new annuity and leave the rest behind, under guidance in Revenue Procedure 2011-38. This is powerful for diversifying or testing a new insurer without committing everything.

In a partial exchange, your basis splits proportionally. If you move half the contract value, you move half the basis and half the gain. The consequence of misunderstanding this is a mismatched tax picture across two contracts.

There is a critical trap: under Rev. Proc. 2011-38, if you take a withdrawal from either contract within 180 days of a partial exchange, the IRS may collapse the transaction and tax it. A common misconception is that the new and old contracts are fully independent the moment the transfer clears — they are not for those 180 days. What you should do: avoid touching either contract for at least 180 days after a partial exchange, and mark that date on your calendar.

A Worked Example: Partial Exchange

David, 65, owns a $200,000 annuity with a $120,000 basis ($80,000 gain). He moves $100,000 to a new income annuity in a partial 1035 and keeps $100,000 in the old one.

Because he moved half the value, his basis splits in half: each contract now holds $60,000 of basis. His $80,000 gain also splits — $40,000 stays in each. He owes no tax on the move. But if David withdraws $10,000 from the old contract 90 days later, the IRS can treat the whole exchange as taxable, exposing the $40,000 gain. Waiting past day 180 protects him.

Handling Loans, Boot, and Outstanding Debt

“Boot” is anything you receive in the exchange that is not the new contract itself — usually cash. If you take cash out during a 1035, that cash is taxable to the extent of your gain, under the Section 1031(b) rules the code points to. The rest of the exchange can still be tax-free, but the boot is not.

Outstanding policy loans are the sneaky version of boot. If your old life policy has a $20,000 loan and the new policy does not carry it over, that forgiven $20,000 can count as a taxable distribution. The consequence is a 1099-R for income you never saw as cash.

What you should do: pay off or carry over any policy loan before the exchange, and never ask for any cash back during the swap. A common misconception is that a small cash kickback is harmless — it is taxable up to your full gain.

The Process, Forms, and Deadlines

A 1035 exchange has no IRS filing deadline like a tax return, but the mechanics must be exact. The golden rule is that the money moves insurer to insurer — you never take possession. The moment a check is payable to you, the tax-free status is at risk.

Here is the standard process. The whole thing usually takes 2 to 8 weeks, depending on how fast the surrendering insurer releases funds.

Apply for the new contract and tell the new insurer you want a 1035 exchange.
Sign the new insurer’s 1035 exchange / absolute assignment form, which authorizes a direct transfer.
The new insurer requests the funds directly from your old insurer.
The old insurer sends the cash value straight to the new insurer — not to you.
You receive a Form 1099-R with code 6 in Box 7, which signals a tax-free 1035 exchange.

That code 6 is your proof. The consequence of a wrong code — say code 7 (normal distribution) or code 1 (early distribution) — is that the IRS thinks you took a taxable payout. What you should do: when the 1099-R arrives in January, confirm Box 7 shows code 6, and if it is wrong, contact the insurer immediately for a corrected form before you file. If you ever need to report the math, the figures flow onto your Form 1040 even when the taxable amount is zero.

Named Examples in Action

Susan upgrades a stale life policy. Susan, 58, owns a universal-life policy from the 1990s with a $45,000 cash value and a $30,000 basis. Her health improved after quitting smoking. She does a 1035 into a modern policy with the same death benefit at lower cost. She pays no tax, keeps her $30,000 basis, and locks in better pricing.

Robert funds long-term care. Robert, 70, holds a non-qualified annuity worth $90,000 with a $50,000 basis, meaning a $40,000 taxable gain if surrendered. He 1035-exchanges it into a hybrid LTC contract. The $40,000 gain is never taxed, and his future LTC benefit payments come out tax-free.

Linda gets tripped by boot. Linda, 55, exchanges a $120,000 annuity ($70,000 basis) into a new one but asks for $10,000 “to cover expenses.” That $10,000 is taxable as gain, and because she is under 59½, she also owes a 10% penalty — about $1,000 extra — on top of income tax.

Mistakes to Avoid

Taking the check yourself. If funds are payable to you, the IRS treats it as a taxable surrender, not an exchange.
Changing the contract owner. A mismatched owner on the old and new contract breaks tax-free status and triggers tax on the gain.
Exchanging in a forbidden direction. Annuity-to-life or LTC-to-annuity is fully taxable in the year you do it.
Ignoring a policy loan. An uncarried loan becomes taxable boot and generates a surprise 1099-R.
Withdrawing within 180 days of a partial exchange. This can collapse the whole transaction into a taxable event.
Surrendering before the new contract is approved. A gap means you held cash, which is a taxable distribution.
Trusting a code 7 or code 1 on the 1099-R. Only code 6 confirms a tax-free 1035; a wrong code invites an IRS notice.
Overlooking surrender charges. The old contract may impose a fee that eats your value even though no tax is due.

Do’s and Don’ts

Do:

Do keep proof of your original basis, because the new insurer may not have it and you will need it later.
Do insist on a direct insurer-to-insurer transfer, so you never receive taxable cash.
Do verify the swap direction is legal before signing, since the wrong direction is fully taxable.
Do wait at least 180 days after a partial exchange before any withdrawal, to avoid collapse of the deal.
Do check the new contract’s surrender period and fees, because a tax-free swap can still be a bad financial deal.

Don’t:

Don’t change the owner during the exchange, as that breaks tax-free treatment.
Don’t take any cash “boot,” because it is taxable up to your full gain.
Don’t confuse a 1035 with a 1031 or an IRA rollover — different rules apply.
Don’t exchange an annuity into life insurance; it is not allowed and is fully taxed.
Don’t file your return until you confirm Box 7 shows code 6 on the 1099-R.

Pros and Cons

Pros:

Tax deferral preserved: your gain is not taxed today, keeping more money compounding.
Lower fees possible: you can escape a high-cost annuity or outdated policy.
Better features: newer contracts may offer stronger income riders or guarantees.
LTC funding: old gains can become tax-free long-term care coverage.
Basis protected: your original investment carries over and shelters future income.

Cons:

Surrender charges: the old contract may penalize you for leaving early.
New surrender period: the new contract often restarts a multi-year lock-up.
One-way directions: you cannot reverse certain swaps, like into LTC.
Boot and loan traps: cash or loans can quietly create taxable income.
Complexity: a small paperwork error can convert the whole move into a tax bill.

When to Call a Professional

Most straight annuity-to-annuity swaps are routine, and the receiving insurer’s 1035 desk handles the mechanics. But some situations are complex enough to warrant paid help before you sign anything.

Call a CPA or tax advisor if your contract has an outstanding loan, if you are attempting a partial exchange, or if you are unsure of your cost basis. A fee-only financial planner can confirm the new contract is actually better, not just newer. Expect to pay a few hundred dollars for a focused review — far less than the tax on a botched exchange.

A licensed insurance agent or the insurer’s exchange department typically completes the forms at no extra cost, since the new contract pays them. The consequence of skipping professional review on a complex swap is a five-figure tax surprise that no one warned you about.

What to Do Next

Pull your contract statements and find your cost basis — total paid in, minus prior withdrawals.
Confirm the swap direction is allowed using the table above, or ask the receiving insurer’s 1035 desk.
Compare surrender charges and the new surrender period so the swap makes financial sense, not just tax sense.
Pay off or carry over any policy loan before the transfer to avoid taxable boot.
Complete the new insurer’s 1035 assignment form and require a direct insurer-to-insurer transfer.
Mark the 180-day date if it is a partial exchange, and do not withdraw before then.
Check the January 1099-R for code 6 in Box 7 before you file your return.

FAQs

What can you exchange tax-free in a 1035 exchange?

Life insurance, endowment, annuity, and qualified long-term care contracts — but only in IRS-allowed directions for 2025. Life is most flexible; annuities go only to annuities or LTC; LTC goes only to LTC.

Is a 1035 exchange really tax-free?

Yes, the gain is not recognized at the time of the swap, under Section 1035. The gain is deferred, not erased — you pay tax later when you withdraw money from the new contract.

Can I exchange an annuity for life insurance?

No. The tax code does not allow it. Annuities can only become another annuity or a qualified LTC contract; an annuity-to-life swap is treated as a taxable surrender of the full gain.

Can I do a partial 1035 exchange?

Yes, you can move part of an annuity to a new annuity under Rev. Proc. 2011-38. Basis and gain split proportionally, but avoid withdrawals from either contract for 180 days.

Does my cost basis carry over?

Yes, your original basis transfers unchanged to the new contract. If you paid $50,000 into a contract now worth $80,000, the new contract keeps the $50,000 basis and the $30,000 embedded gain.

What is “boot” in a 1035 exchange?

Boot is cash or non-like value you receive during the swap. It is taxable up to the amount of your gain, even if the rest of the exchange stays tax-free, so never request cash back.

How is a 1035 exchange reported to the IRS?

On Form 1099-R with code 6 in Box 7, which the insurer issues by January 31. Code 6 signals a tax-free 1035 exchange; a different code suggests a taxable distribution.

Can I change the owner during a 1035 exchange?

No. The owner on the old and new contracts must match. Changing the owner generally breaks tax-free treatment and can make the entire gain taxable in that year.

Is there a deadline for a 1035 exchange?

No fixed IRS deadline like a tax-return date applies, but the transfer must go insurer-to-insurer. The process usually takes 2 to 8 weeks, depending on the surrendering insurer.

Can I 1035 exchange into long-term care insurance?

Yes, since exchanges after December 31, 2009, you can move a life policy or annuity into a qualified LTC contract tax-free. The resulting LTC benefit payments are generally received tax-free.

Does a 1035 exchange avoid surrender charges?

No. A 1035 only handles taxes. Your old contract may still impose surrender charges, and the new contract often starts a fresh multi-year surrender period.

Do all states follow the federal 1035 rules?

Generally yes for income tax, since most states start from federal taxable income, but state insurance regulators control suitability and premium-tax rules. Confirm your state’s specifics before exchanging.

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