1035 Exchange vs 1031 Exchange: Annuity, Boot, 180 Days, NIIT

The two sections, side by side

Both sections say that no gain or loss is recognized when you swap one thing for a similar thing, and both leave the tax to later. The similarity ends there. One covers buildings, the other covers contracts with insurance companies, and the mechanics around the swap differ.

Source: 26 U.S. Code Sections 1031, 1035, 1223, 72 (Cornell LII); 26 CFR 1.1035-1; Rev. Proc. 2011-38; IRS Publications 575 and 559; Instructions for Form 8824 (2025); 2026 Instructions for Forms 1099-R and 5498; read on October 21, 2026. The last two rows combine statute and IRS publication text; the comparison itself is our reading.

What can be swapped for what under Section 1035

The statute is a list, and the list has a direction. Section 1035(b) defines the terms: an endowment contract “depends in part on the life expectancy of the insured”, an annuity contract may be “payable during the life of the annuitant only in installments”, and a life insurance contract is one “not ordinarily payable in full during the life of the insured”.

Source: 26 U.S. Code Section 1035 and 26 CFR 1.1035-1 (Cornell LII); IRS Publication 575 (2025), read on October 21, 2026. The last two rows are our reading of the two statutes together.

Two sentences from the regulation carry most of the weight. The first: “This section and section 1035 do not apply to transactions involving the exchange of an endowment contract or annuity contract for a life insurance contract, nor an annuity contract for an endowment contract.” The second keeps the exchange from drifting to a new person: swapping annuity for annuity “is limited to cases where the same person or persons are the obligee or obligees under the contract received in exchange as under the original contract”. The practical consequence of the first is that moving from a deferred annuity to a life policy, to get a death benefit, is a taxable event on all the gain.

Why a 1031 cannot become a 1035, and what the exit looks like

Real estate cannot be exchanged into an annuity under either section, so a seller who wants an annuity pays the tax on the sale first. Section 1031(a)(1) allows an exchange only “solely for real property of like kind”, so an annuity is not what the 45-day and 180-day clock is counting toward. Section 1035(a) starts from an insurance contract and ends at one. We found no provision that links the two lists (our reading of both statutes; the regulation on the second, 1.1035-1, speaks only of contracts).

That matters for a reader who has been rolling a rental or an interest in a DST from one 1031 to the next and now wants to stop. The tax on the deferred gain is the price of leaving the chain, and the annuity does not remove it. Here is what a sale and an annuity purchase look like, at the highest federal rates, on numbers we picked:

Source: 26 U.S. Code Sections 1(h) and 1411 (Cornell LII), read on October 21, 2026. The lower rate bands in Section 1(h) and your state's tax would reduce or add to this; the example shows the structure, not your bill.

The alternatives to that sale are not annuities, they are other ways to move or spread the same gain, and each has its own page: another 1031 into like-kind property, which can include a DST interest (our 1031 rules and the DST guide); an installment sale, which spreads the gain over the payments (installment sales); a DST sold into a REIT through a 721 exchange (DST to REIT); or keeping the property until death, when it generally takes a basis equal to its fair market value (Pub. 559). Section 1014(c) withholds that step-up from “a right to receive an item of income in respect of a decedent under section 691”. The IRS texts we saved do not say whether the untaxed gain inside a nonqualified annuity is such a right, so we do not decide it here; it is a question for the person who prepares your return. What Section 72(s) does say is that a nonqualified annuity must be paid out within 5 years of the holder's death unless a designated beneficiary takes it over a lifetime, a timing rule a building does not have.

For a reader who already owns an annuity or a life policy, the opposite problem is common and has a clean answer: Section 1035 lets you change the contract without paying tax. The case that is easy to get wrong is the partial exchange.

Partial exchange of an annuity: Rev. Proc. 2011-38

Rev. Proc. 2008-24 first set a 12-month test for splitting an annuity between two insurers; Rev. Proc. 2011-38 replaced it with a shorter safe harbor that is still the guidance in force: the 2026 Form 1099-R instructions cite it by name for “partial exchanges of annuity contracts”. These are its operative parts.

Source: Rev. Proc. 2011-38, Internal Revenue Bulletin 2011-30 (July 25, 2011), read on October 21, 2026.

A partial exchange in numbers (our arithmetic)

An annuity is worth $500,000, with $300,000 of investment in the contract and $200,000 of gain. The owner, age 55, moves 60% of its cash value, $300,000, by direct transfer to a new annuity at another company. IRS Publication 575 has the same shape of example: with 60% assigned, the investment in the new contract is 60% of the old investment and the old contract keeps 40%.

The total gain is still $200,000; it has only been split. Now suppose that on day 100 the owner takes $50,000 out of the old contract. That falls inside the 180 days, so section 4.01 no longer protects the transfer, and section 4.02 applies. If the $50,000 is treated as an ordinary withdrawal, it comes out income first (Section 72(e)(2)(B)); the old contract holds $80,000 of gain, so all $50,000 is income, and the 10% additional tax of Section 72(q) adds $5,000 under age 59½. If the withdrawal is treated as boot, gain is recognized up to $50,000, the same amount. The IRS has not said that the whole $300,000 would be re-characterized, but section 4.02 leaves facts and circumstances open; had it been, $200,000 would be income and the additional tax $20,000. The date to remember: a new contract placed in force on March 2, 2027 is watched through August 28, 2027, a Saturday.

What 34 insurers' prospectuses say

Insurers write this rule into their prospectuses, and they do not all write it the same way. We took the latest annuity or variable life prospectus filed with the SEC between October 21, 2025 and October 21, 2026 for 34 insurer groups found by EDGAR full-text search, saved each one, and counted what it says. Five of the documents are pre-effective drafts (Form 485APOS). The count is our regular-expression count and the file lists each document with its accession number.

Source: 34 prospectus documents (Forms 485BPOS, 485APOS, N-4, N-4/A and 497) filed with the SEC from January 2026 to October 2026, listed in the data file with accession numbers; counts are ours.

Three of the sentences are worth reading as written. Allianz tells the owner that “no distributions or withdrawals can occur from the old or new annuity contract within 180 days of the partial exchange, unless you qualify for an exception to this rule.” RiverSource says that, per the revenue procedure, “if surrenders are taken from either contract within the 180-day period following a partial 1035 exchange, the IRS will apply general tax principles to determine the appropriate tax treatment of the exchange and subsequent surrender.” Security Benefit says: “A tax-free partial exchange may become taxable if an advisory fee is paid from your Contract Value within 180 days of the partial exchange.” For an owner paying an adviser out of the annuity, that is money received from the contract inside the window (our reading of section 4.01). Two more points from the same documents: Equitable states that “Section 1035 exchanges are generally not available after the death of the owner”, and Fidelity's contract says that “Withdrawals or partial 1035 exchanges will reduce the Death Benefit proportionately”, so a guaranteed death benefit can shrink on a partial exchange. TIAA reports that the IRS guidance also provides that partial exchanges “are disregarded” when counting contracts bought from one insurer in 12 months, which matches section 4.03.

Brighthouse puts the state of the law in one sentence: “Some of the ramifications of a partial exchange remain unclear.” And Corebridge says that “it was generally understood that only the exchange of an entire annuity contract, as opposed to a partial exchange, would be respected by the IRS as a tax-free exchange” until the revenue procedure.

Boot and basis: the one rule they share

When you receive cash in a swap, Section 1031(b) taxes the gain only up to the cash, and Section 1035(d) borrows that rule for insurance. Here are two exchanges on the same logic, one in each section, with numbers we picked.

Source: 26 U.S. Code Sections 1031(b), (c), (d) and 1035(d) (Cornell LII), read on October 21, 2026. Mortgage relief, which counts as boot in a 1031, and exchange costs are left out; the Form 8824 instructions list the liabilities that count.

The life policy has an extra cost the rental does not. A death benefit under a life insurance contract is generally excluded from income (Pub. 559); the annuity that replaces it has none. T.D. 10052 adds a rule for life-to-life exchanges: when less than all of the old policy's proceeds were excludable, the final regulations provide that “the amount of boot received tax-free in a section 1035 exchange will reduce the amount of proceeds” excludable under Section 101(a), as the preamble explains it. If the policy you are exchanging was ever bought or sold as a settlement, that rule matters.

The 3.8% tax on annuity income

Section 1035 defers income tax; it does not turn annuity income into something the 3.8% tax ignores. Net investment income includes “gross income from interest, dividends, annuities, royalties, and rents” (Section 1411(c)(1)(A)(i)), and the regulation's own example has an individual who “includes the $50,000 of annuity income in net investment income”. The tax is 3.8% of the lesser of net investment income or the amount of modified adjusted gross income over $250,000 (joint or surviving spouse), $125,000 (married filing separately) or $200,000 (anyone else), amounts written into the statute and not adjusted for inflation. Distributions from a plan or arrangement under Sections 401(a), 403(a), 403(b), 408, 408A or 457(b) are outside it (Section 1411(c)(5)), so an annuity held inside an IRA is a different question from a nonqualified one. Our net investment income tax guide covers the real estate side: the sale of a rental, passive rent and the real estate professional exception.

Two things in the annuity world are specific. First, only the taxable part counts. When an annuity is paid out as a stream of payments, Section 72(b)(1) excludes “that part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract ... bears to the expected return”, and Section 72(b)(2) caps the excluded part at the unrecovered investment. Second, a withdrawal before the annuity starting date comes out gain first (Section 72(e)(2)(B)), which makes the whole withdrawal taxable until the gain is used up.

Two examples (our arithmetic)

A single filer has $190,000 of income from other sources and receives $40,000 of taxable annuity income. Modified adjusted gross income is $230,000, $30,000 over the $200,000 threshold. The tax is 3.8% of the lesser of $40,000 and $30,000, which is $1,140. An annuity paying $24,000 a year for life, bought with $250,000 and with an expected return we assume to be $480,000 (the real figure comes from the IRS tables), has an exclusion ratio of 52.08%: $12,500 of each year's payments is excluded and $11,500 is taxable, until the $250,000 is recovered after 20 years, after which the full $24,000 is taxable. In this example the $11,500 is what feeds the 3.8% tax in the early years.

What changed in 2025 and 2026

What a reader can do with this

• Start from the contract, not from the sale. If you hold an old annuity or policy, Section 1035 changes the contract without tax. If you hold a building, no insurance product is a tax-free destination for it; the choice is another like-kind property or a taxable sale.
• Ask for a direct transfer in writing. A partial annuity exchange is safe only as a direct insurer-to-insurer transfer; a check that passes through your hands was treated as a distribution.
• Put the 180 days in a calendar. Day 1 is the date the new contract is placed in force. Do not take a withdrawal, a surrender or an advisory fee from either contract inside the window, unless the payment is an annuity for life or for 10 years or more.
• Read your insurer's prospectus for the phrase “partial exchange”. The census above shows that wording runs from “general tax principles” to “will not receive tax-free treatment”. Ask what the carrier does if a withdrawal falls inside the window, and what the new contract's surrender charge and death benefit do.
• Check the direction. An annuity cannot become a life policy tax-free. A life policy can become an annuity, at the price of the death benefit.
• If you are leaving a 1031 chain, price the sale first. Compare the tax at the top of the table above with your own bracket, then ask whether an installment sale, a DST to REIT exchange or another 1031 changes it.
• If the annuity will pay out, estimate the 3.8% tax with the exclusion ratio and your expected income, and check the thresholds the statute fixes at $200,000 and $250,000.
• If an old policy is involved, check T.D. 10052 for exchanges after July 9, 2026, in particular if it was ever sold or bought as a settlement.

FAQ

Sources, read and saved on October 21, 2026: 26 U.S. Code Sections 1, 72, 1014, 1031, 1035, 1223 and 1411 (Cornell Legal Information Institute); 26 CFR 1.1035-1, 1.1031(b)-1, 1.1031(d)-1 and 1.1411-4 (LII); Rev. Proc. 2011-38, Internal Revenue Bulletin 2011-30; IRS Publications 575 (2025) and 559; Instructions for Form 8824 (2025); 2026 Instructions for Forms 1099-R and 5498; T.D. 10052, Internal Revenue Bulletin 2026-31 (July 27, 2026); Pub. L. 119-21 (govinfo.gov); and the latest prospectus found by EDGAR full-text search for 34 insurer groups (Forms 485BPOS, 485APOS, N-4, N-4/A and 497, filed January to October 2026), saved in full with the search and download scripts and a per-document index. Counts of insurers, ratios and every worked example are our arithmetic or our reading. This is analysis of public documents, not investment, legal or tax advice.