The Circle of Life (Insurance): Final Regulations Provide Welcome Conclusion on Section 1035 Life Insurance Policy Exchanges

On July 9, 2026, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (the IRS) issued final regulations (T.D. 10052, 91 Fed. Reg. 42345) (the 2026 Regulations) that provide long-awaited guidance pertaining to the exchange of life insurance contracts qualifying for nonrecognition of gain or loss. In particular, the 2026 Regulations resolve the unintended tax consequences of certain exchanges of life insurance contracts that resulted from legislative changes enacted by the Tax Cuts and Jobs Act of 2018 (TCJA) to Sections 101 and 6050Y of the Internal Revenue Code of 1986, as amended (the Code). The 2026 Regulations also include simplified reporting requirements and rules for life insurance contracts acquired by corporations in certain tax-deferred mergers and acquisitions.

Background

Tax Deferral and the Death Benefit Exclusion

While sellers generally are liable for tax on any gain associated with the sale of a life insurance contract, Section 1035 of the Code permits the deferral of tax on gains and losses on qualifying exchanges of life insurance contracts with respect to the same insured life (Section 1035 Exchanges).

Separately, Section 101(a)(1) of the Code generally excludes from gross income the proceeds received under a life insurance contract paid upon the death of the insured (the Death Benefit Exclusion), but the Death Benefit Exclusion may not apply to life insurance contracts received in certain exchanges. In particular, if a life insurance contract is sold or otherwise transferred for valuable consideration, the Death Benefit Exclusion generally is limited to (i) the actual value of the consideration and (ii) the premiums or other amounts subsequently paid by the transferee of the contract (Transfer-for-Value Limitation).

Many practitioners would conclude that a life insurance contract surrendered in a Section 1035 Exchange was not, strictly speaking, transferred for purposes of the Transfer-for-Value Limitation, though prior to the enactment of the TCJA, this was a distinction without a difference. This is because the Transfer-for-Value Limitation did not apply if the transferee’s basis in the surrendered contract was determined by reference to the transferor’s basis in that contract (the Carryover Basis Exception), a condition that is generally met for life insurance contracts in a Section 1035 Exchange. Thus, prior to the TCJA, it was generally understood that a Section 1035 Exchange was either (a) not a transfer for purposes of the Transfer-for-Value Limitation or (b) a transfer that qualified for the Carryover Basis Exception.

Impact of the TCJA

The TCJA and the final regulations implementing the TCJA (T.D. 9879, 84 Fed. Reg. 68042) (the 2019 Regulations) changed this analysis by eliminating the Carryover Basis Exception for a transfer constituting a “reportable policy sale” within the meaning of Section 101(a)(3) of the Code and treating a Section 1035 Exchange as a “transfer” that could be a reportable policy sale. Consequently, a Section 1035 Exchange became both (a) a transfer for purposes of the Transfer-for-Value Limitation and (b) a transfer that no longer qualified for the Carryover Basis Exception if it constituted a reportable policy sale.

Under Section 101(a)(3) of the Code, a reportable policy sale is the direct or indirect acquisition of an interest in a life insurance contract by a person who, at the time of acquisition, has “no substantial family, business, or financial relationship with the insured” (other than the interest in the life insurance contract itself). An example of such a life insurance contract is a corporate-owned life insurance (COLI) policy insuring the life of an employee of the policyholder that continues in effect after that employee leaves the company: while the corporate-policyholder may have a substantial business relationship with a current employee, that relationship may not exist with a former employee. After the enactment of the TCJA and the 2019 Regulations, a Section 1035 Exchange of COLI policies on former employees was likely a reportable policy sale that resulted in the Transfer-for-Value Limitation being applied to the new contracts issued in the Section 1035 Exchange.

Unintended Consequences and the 2023 Proposed Regulations

In response to comments on the 2019 Regulations, Treasury and the IRS proposed regulations in 2023 (REG-108054-21, 88 Fed. Reg. 57916) (2023 Proposed Regulations) that clarified that “[t]he Section 1035 exchange provisions [in the 2019 Regulations] were not intended to change the [application of the Transfer-for-Value Limitation on] the policyholder’s new contract if the policyholder’s old contract was never transferred in a reportable policy sale.”

The 2023 Proposed Regulations therefore removed the implication in the 2019 Regulations that a Section 1035 Exchange was a “transfer” for purposes of the Transfer-for-Value Limitation. They further clarified that the Transfer-for-Value Limitation applied to the new contract issued in a Section 1035 Exchange only to the extent that the Transfer-for-Value Limitation applied to the surrendered contract. In other words, a Section 1035 Exchange could not remove a Transfer-for-Value Limitation that previously applied to the surrendered contract, but it would not in and of itself result in the application of the Transfer-for-Value Limitation to the new contract.

The 2026 Regulations Relating to 1035 Exchanges

Adoption of 2023 Proposed Regulations

The 2026 Regulations adopt the position of the 2023 Proposed Regulations that a Section 1035 Exchange generally is not a transfer that could be a reportable policy sale and does not trigger the Transfer-for-Value Limitation. Although taxpayers were already allowed to rely on the 2023 Proposed Regulations, the 2026 Regulations remove the uncertainty around whether the 2023 Regulations would be finalized and in what form.

Other Rules

The 2026 Regulations also include rules on the receipt of cash or other property (boot) in connection with a Section 1035 Exchange. Specifically, if any amount of boot would have reduced the Death Benefit Exclusion with respect to the surrendered life insurance contract in a Section 1035 Exchange, the same amount of boot will also reduce the Death Benefit Exclusion with respect to the new contract issued in the Section 1035 Exchange.

Finally, the 2026 Regulations do not expand existing information reporting requirements with respect to a Section 1035 Exchange even if the surrendered contract was previously transferred in a reportable policy sale. The reporting obligation remains with the issuer of the surrendered policy generally by using IRS Form 1099-R. Future changes to IRS Form 1099-R, however, may require indicating that the Section 1035 Exchange being reported is an exchange of a contract that was previously transferred in a reportable policy sale.

The 2026 Regulations Relating to Certain Mergers and Acquisitions

The 2023 Proposed Regulations also proposed that certain ordinary course mergers and acquisitions of trades or businesses that own life insurance not be treated as reportable policy sales subject to the Transfer-for-Value Limitation. This narrow exception from treatment as a reportable policy sale applies only to certain direct acquisitions of life insurance contracts from a corporation by a corporation in a transaction that qualifies as a tax-deferred reorganization pursuant to Section 368 of the Code. In addition, among other requirements, the target corporation must not be in the business of investing in life insurance, and no more than 5% of the gross value of its assets can consist of life insurance contracts. The 2026 Regulations adopt this rule without expanding the exception to include taxable transactions or transactions that involve partnerships, though Treasury and the IRS invite additional comments on this issue.

Application

The 2026 Regulations generally apply to Section 1035 Exchanges and acquisitions of an interest in a life insurance contract occurring on or after July 9, 2026, and taxpayers may elect to apply the rules retroactively to transactions occurring after December 31, 2017.

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Paul Hastings’ global insurance and tax practices regularly advise on matters affecting the insurance industry its stakeholders in areas such as Section 1035 Exchanges, mergers and acquisitions, finance and capital markets, and insurance regulation.