Jennifer Karpchuk’s article, “Tax Change for the New Year: Pa. Recognizes Section 1031 Like-Kind Exchanges” in The Legal Intelligencer
Tax Change for the New Year: Pennsylvania Recognizes §1031 Like-Kind Exchanges
By Jennifer W. Karpchuk
The New Year brings with it a welcomed tax change to Pennsylvania: the recognition of Internal Revenue Code (IRC) §1031 like-kind exchanges. Under the federal tax rules, gain or loss is recognized upon the disposition of property, including dispositions involving an exchange of property. However, §1031 is an exception to the general rule – it provides that the recognition of gain or loss can be deferred under certain circumstances when property held for productive use in a trade or business or for investment is exchanged for property of a like kind and is held for productive use in business or investment.
Section 1031 offers important advantages to real estate investors. It allows for the immediate deferral of gain, which in turn creates increased cash flow from the money that is retained by not having to immediately pay tax on the gain – thereby allowing for the growth of real estate portfolios.
Since §1031 is a federal rule, states are not required to conform to it. States conform to federal tax rules in one of three ways: (1) rolling conformity (states conform to the IRC as currently in effect); (2) fixed date conformity (states conform to specific sections of the IRC in effect on a specific date); or (3) selective conformity (states conform to specific sections of the IRC). Pennsylvania is a selective conformity state.
While states have their own specific requirements related to §1031 exchanges, including withholding, filing obligations and claw back rules, prior to 2023 Pennsylvania was an outlier as the only state that altogether failed to recognize §1031 exchanges. Thus, while individuals engaging in §1031 exchanges received a deferral of gain for federal income tax purposes, the gain was nonetheless picked up for Pennsylvania personal income tax purposes. Taxpayers challenged the Pennsylvania Department of Revenue on the issue recently and were met with defeat at the Commonwealth Court. In Pearlstein v. Commonwealth, Pa. Commw. Ct., Nos. 741-743 FR 2017, 12/2/2021, a panel of the Commonwealth Court upheld the Department’s position, finding that gains from like-kind exchanges are recognized when the exchange occurs because Pennsylvania law does not grant a tax deferral. Exceptions were filed with the court on January 3, 2022. The case will be considered by the full court with a decision likely during 2023.
Going forward, the issue has been resolved in favor of taxpayers. Effective January 1, 2023, pursuant to Act 53 of 2022, Pennsylvania will join the rest of the country in recognizing §1031 exchanges.
However, there are some complications. Most §1031 exchanges require the use of a qualified intermediary or exchange accommodation titleholder. Unlike many other states, Pennsylvania does not currently have an exemption for realty transfer tax purposes for the transfer of property from a qualified intermediary or exchange accommodation titleholder to the taxpayer. The result is a duplicate tax liability, which can be further compounded by an additional duplicative local transfer tax in certain cities, including Philadelphia.
Further, notwithstanding the change at the state level, Philadelphia continues not to recognize IRC §1031 in full. The Philadelphia Business Income and Receipts Tax (BIRT) is composed of a gross receipts portion and a net income portion and is imposed upon every individual, partnership, association, limited liability company and corporation engaged in a business, profession or other activity for profit within the city. Regarding the gross receipts portion of the BIRT, there is no provision in the regulations that allows for §1031 treatment when reporting gains on the sale, exchange or other disposition of property. Thus, the Philadelphia Department of Revenue has taken the position that Philadelphia does not recognize IRC §1031 for purposes of the gross receipts portion of the BIRT (https://www.phila.gov/media/20220915095421/Guidance-on-IRC-Sec-1031-BIRT-NPT.pdf).
For the net income portion of the BIRT, whether IRC §1031 is honored depends upon whether a taxpayer is a Method I or Method II filer. Method I filers cannot use IRC §1031 because Method I filers look to the Philadelphia Code, which does not recognize IRC §1031. However, taxpayers who elect Method II start with taxable income that is returned to and ascertained by the federal government. Thus, for Method II filers, IRC §1031 is recognized for net income tax purposes.
Pennsylvania still presents a somewhat complicated landscape for IRC §1031 like-kind exchanges. However, it has moved in the right direction in conforming to the federal tax treatment for such exchanges.
Jennifer Karpchuk is the co-chair of the State and Local Tax (SALT) Controversy and Planning practice at Chamberlain Hrdlicka. She may be reached at email@example.com.
Reprinted with permission from the December 22, 2022, edition of The Legal Intelligencer © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or firstname.lastname@example.org.