The very name of the code is nontaxable 1035 exchange. The IRS describes the law regarding this below. I would call back, armed with the Revenue Procedure and ask why they are making a nontaxable exchange taxable.
Rev. Proc. 2011-38
SECTION 1. PURPOSE
This revenue procedure addresses the tax treatment of certain tax-free
exchanges of annuity contracts under § 72 and § 1035 of the Internal Revenue
Code.
.01 Section 1035(a)(3) provides that no gain or loss shall be recognized
on the exchange of an annuity contract for another annuity contract. The
legislative history of § 1035 states that exchange treatment is appropriate for
"individuals who have merely exchanged one insurance policy for another better suited to their needs." H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954).
Section 1.1035-1 of the Income Tax Regulations provides that "the exchange,
without recognition of gain or loss, of an annuity contract for another annuity
contract under § 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract."
1035
