Policy Loans BECAUSE YOU ASKED. Table of contents. 1. What is the tax effect of a 1035 exchange of a policy subject to an ADVANCED MARKETS

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1 ADVANCED MARKETS Policy Loans BECAUSE YOU ASKED The transfer of a life insurance policy can take many forms, such as a gift of a policy to a child, to an irrevocable life insurance trust (ILIT), or to a charitable organization. However, when a life insurance policy is transferred that is subject to an outstanding loan, there may be federal income tax consequences to consider. Accordingly, an analysis of the application of the rules controlling basis and gain recognition under the Internal Revenue Code should be undertaken before entering into such transaction. This piece is intended to provide a basic overview of the rules pertaining to policy loans. Table of contents 1. What is the tax effect of a 1035 exchange of a policy subject to an outstanding loan? 2. What are the tax consequences of making a gift of a life insurance policy that is subject to a loan? 3. Can the gift of a policy subject to a loan trigger a transfer-for-value? 4. What if an encumbered policy is gifted to an ILIT instead of an individual? 5. What are the tax consequences of giving a policy with an outstanding loan to a charitable organization? 1. What is the tax effect of a 1035 exchange of a policy subject to an outstanding loan? A 1035 exchange of a policy on which there is an outstanding policy loan generally can be dealt with in one of three ways: 1. the policy loan can be carried over to the new policy; 2. the loan can be paid off at or prior to the 1035 exchange using external funds; or 3. the loan can be paid off at or prior to the 1035 exchange using cash value. The tax consequences will vary depending on the method chosen. Carry-Over Loan: If the policy loan is carried over to the new policy, the owner of the policy will not recognize any income on the exchange (and therefore will not have to pay any income taxes). In other words, by carrying over LIFE /17 Not valid without all pages. PAGE 1 OF 6 ADVANCED MARKETS

2 ADVANCED MARKETS BECAUSE YOU YOU ASKED ASKED the loan to the new policy, the owner defers the built-in gain of the old policy and carries over such gain to the new policy. To account for such deferral, the federal income tax basis of the new policy will be equal to the carry-over basis of the old policy plus the amount of any additional premium paid with respect to the new policy (but not including unrelated adjustments). 1 Extinguish Loan with External Funds: If the loan is paid off with external funds (i.e., the owner provides cash to repay the policy loan), there generally will be no adverse tax consequences. In this case, the owner has not accessed any of the policy s cash values to repay the policy loan, and therefore there has been no receipt of other property or money for the purposes of the boot recognition rules of 1031(b). Extinguish Loan with Cash Value: Using policy values to pay off the loan may have adverse tax consequences if the policy is in a gain position prior to the exchange. Generally speaking, the IRS considers cash value used to extinguish a loan during a 1035 exchange or within a short time before or after the exchange to be other money or property (aka boot ) received, and thus not eligible for deferral under In this case, gain will have to be recognized in an amount equal to the lesser of: (1) the amount of boot (i.e. the payoff value of the loan) received and (2) amount of gain in the original contract EXAMPLE Assume that prior to a 1035 exchange, the client held a non-mec policy with $1,000 of gross cash value, a $400 outstanding loan, a basis of $700, and the loan was extinguished using internal cash value. GAIN CALCULATION Cash Value transferred to new policy $600 Cash used to extinguish loan ( boot ) + $400 Total consideration received in exchange $1,000 Basis in original policy (premiums paid) - $700 Loan carried over to new policy - $0 Gain realized $ (b) gain recognized $300 Gain from boot = lesser of boot and gain in the contract BASIS CALCULATION Basis of old policy $700 Boot received - $400 Amount of 1031(b) gain recognized + $300 Basis of new policy $600 FOR MORE INFORMATION ON THIS TOPIC, PLEASE SEE OUR BYA: 1035 TAX-FREE EXCHANGES OF LIFE INSURANCE 2. What are the tax consequences of making a gift of a life insurance policy that is subject to a loan? The IRS treats a gift of a policy subject to an outstanding policy loan as a part sale/part gift transaction. 2 The value of the outstanding loan is treated as consideration received from the donee (the sale portion) and the remaining value (generally the interpolated terminal reserve value minus the loan amount) is deemed to be the gift portion. Because the donor is deemed to receive consideration in such a transaction, equal to the amount of the loan, the donor may need to recognize gain as a result of the deemed sale. Not valid without all pages. PAGE 2 OF 6 ADVANCED MARKETS

3 Generally, if the value of the loan on the date of the gift is less than the donor s basis, the donor will not recognize any gain on the transfer of the policy. However, if the loan balance is greater than basis, gain will be recognized to the extent that the loan exceeds basis. The basis of the policy in the hands of the donee will be: the greater of (a) the amount deemed paid by the donee (the loan amount) or (b) the transferor s adjusted basis for the property at the time of the transfer, plus the amount, if any, of any increase authorized by the Code for gift taxes paid. 3 The tax results of a gift of an encumbered policy are illustrated by the following examples: EXAMPLE 1: LOAN LOWER THAN BASIS Father gifts a life insurance policy on his life to his daughter. Prior to transfer policy has $1,000 gross CSV, $400 outstanding loan, and $600 basis. Father transfers policy to daughter subject to the loan and is not liable for gift taxes. GAIN CALCULATION Amount of outstanding loan ( sale ) $400 Donor s basis in policy - $600 Gain realized $0 BASIS CALCULATION (A) Donor s basis in policy $600 (B) Loan Amount $400 (C) Gift taxes paid by Donor $0 Basis of new policy (greater of A and B + C) $600 EXAMPLE 2: LOAN GREATER THAN BASIS Father gifts a life insurance policy on his life to his daughter. Prior to transfer policy has $1,000 gross CSV, $800 outstanding loan, and $600 basis. Father transfers policy to daughter subject to the loan and is not liable for gift taxes. GAIN CALCULATION Amount of outstanding loan ( sale ) $800 Donor s basis in policy - $600 Gain realized $200 BASIS CALCULATION (A) Donor s basis in policy $600 (B) Loan Amount $800 (C) Gift taxes paid by Donor $0 Basis of new policy (greater of A and B + C) $800 Not valid without all pages. PAGE 3 OF 6 ADVANCED MARKETS

4 3. Can the gift of a policy subject to a loan trigger a transfer-for-value? Yes. As noted above, the transfer of a policy subject to a loan is considered a part gift/part sale transaction. Consequently, the transfer-for-value (TFV) rules will apply unless an exception exists under 101(a)(2). One of the exceptions to the TFV rule is known as the basis exception. Under the basis exception, if the transferee s (aka the donee ) basis in the contract is determined in whole or in part with reference to the basis of the contract in the hands of the transferor (aka the donor ) then there is no transfer-forvalue issue. As discussed in Question 2, basis is determined in a part gift/part sale transaction by the greater of: (i) the amount paid by the transferee (e.g. amount of debt assumed) or (ii) the transferor s adjusted basis on the property at the time of transfer. 4 Accordingly, if the loan is less than basis, there will be no transfer-for-value issue because the transferee/donee will take the same basis as held by the donor. If, however, the loan exceeds the basis in the contract, then basis to the transferee is determined using the loan amount and the basis exception will not apply. In that case, the death benefit will be subject to ordinary income taxes and will not be received 100% income-tax free, unless another exception to the transfer-for-value rule was present at the time of transfer. 5 Consider the below examples to better understand the application of the basis exception. FOR A MORE THOROUGH DISCUSSION OF THE TRANSFER- FOR-VALUE RULES, SEE OUR BYA: UNDERSTANDING TRANSFER-FOR- VALUE EXAMPLE 1 LOAN DOES NOT EXCEED BASIS Mother transfers a policy on her life to Daughter with an adjusted basis of $500, a loan of $400, and a fair market value of $800. The basis in the hands of Daughter is $500 (the greater of Mother s adjusted basis ($500) and the amount of debt assumed ($400)) and this transaction qualifies for an exception to the transfer-for-value rule. EXAMPLE 2 LOAN EXCEEDS BASIS Father transfers a policy on his life to Son with a basis of $500, and a loan of $700. The basis in Son s hands is $700 (the amount of the debt assumed). Because the loan is in excess of basis, the basis exception does not apply, and upon Father s death, Son will only be able to exclude from gross income death benefit equal to $700, plus any premiums subsequently paid by Son after the transfer. 4. What if an encumbered policy is gifted to an ILIT instead of an individual? If the gift is to an ILIT that is not a grantor-defective trust for federal income tax purposes, then the ILIT is considered to be a separate taxable entity from the donor. In this case, the transaction would receive the same tax treatment and face the same potential tax consequences as a gift of a policy to an individual. However, if the ILIT is taxed as a grantor trust for federal income tax purposes, there should be no income tax effects to the grantor because a grantor generally cannot enter into a taxable transaction with himself. 6 If a policy is gifted to an ILIT with grantor trust rules, there should be no transfer-for-value triggered, even if the policy has a loan in excess of basis. Transfers of a policy to a trust that is a grantor trust as to the insured is deemed to be a transfer directly to the insured, which is one of the exceptions to the transfer-for-value rule. 7 Not valid without all pages. PAGE 4 OF 6 ADVANCED MARKETS

5 5. What are the tax consequences of giving a policy with an outstanding loan to a charitable organization? As previously discussed, a transfer of a policy subject to an outstanding policy loan is treated as a part sale/part gift transaction. This same rule applies to a gift to charity of a life policy subject to an outstanding loan, but the rules regarding basis and gain recognition are a little different. In a charitable part gift/part sale transaction, the donor must allocate his or her basis in the policy between the sale portion of the transaction and the gift portion of the transaction. Treas. Reg requires that this basis allocation be done on a proportionate basis, dividing the basis based on the ratio between the loan value and the total value of the policy. As a result, the donor will always be deemed to have some amount of gain on the transfer and will recognize such gain accordingly. This gain will be offset against any income tax charitable deduction provided by the transfer. However, it is generally only the amount of the part gift to the charity that generates the charitable deduction, which can significantly limit the donor s overall available deduction for the charitable contribution. The following example illustrates the application of the part sale/part gift rules to a charitable donation of a policy encumbered by a loan. Assume that the policy s gross cash surrender value is $1,000, the loan is $800 and the basis is $600. Step 1: Determine what percentage of basis is attributable to loan $800 loan/$1,000 basis = 80% of the value of the policy is the loan Step 2: Allocate basis between part-sale and part-gift Part-sale (i.e., loan) = $480 (80% of total basis of $600) Part-gift (i.e., policy value not subject to loan) = $120 (20% of total basis of $600) Step 3: Determine gain to donor/transferor on the sale portion of transfer Loan ($800) less basis ($480) = $320 gain Step 4: Determine charitable deduction Limited to donor s basis in gifted amount = $120 In this example, by transferring the encumbered policy to charity, donor must recognize $320 of gain resulting from the deemed partial sale, and only receives an income tax deduction equal to $120 (subject to AGI limitations). As illustrated with this example, donating a policy subject to a loan to a charitable organization may not always provide the donor with the income-tax deduction wanted or expected and usually will lead to some gain recognition. NOTE: It is possible that gifting a policy subject to a loan to charity, even if the loan is small, could result in a complete denial of any charitable income tax or gift tax deduction due to the application of charitable split dollar rules under IRC 170(f)(10). Clients should seek tax counsel before transferring a policy subject to a loan to charity. Not valid without all pages. PAGE 5 OF 6 ADVANCED MARKETS

6 1. See Treas. Reg (d) Rev. Rul See Treas. Reg See Treas. Reg See 101(a)(2)(A) and (B) for a list of other exceptions to the transfer-for-value rule. 6. See Rev. Rul Rev. Rul For Financial Professional Use Only. Not intended for use with the General Public. This material does not constitute tax, legal or accounting advice, and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance products are issued by John Hancock Life Insurance Company INSURANCE PRODUCTS (U.S.A.), Boston, MA (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY Not FDIC Insured Not Bank Guaranteed May Lose Value 2017 John Hancock. All rights reserved. Not a Deposit Not Insured by Any Government Agency MLINY Not valid without all pages. PAGE 6 OF 6 ADVANCED MARKETS