Pennsylvania Conforms its State Tax Code to Federal §1031

By: James T. Walther, Esq., LL.M.
General Counsel, Legal 1031 Exchange Services, LLC

 

Summary: Pennsylvania now recognizes 1031 Exchanges for individuals and partnerships. For tax years beginning after December 31, 2022, Pennsylvania will conform its state tax code to Internal Revenue Code §1031. This change will benefit real estate investors and businesses who were subject to state personal income tax even though they completed a tax-deferred 1031 exchange at the federal level. This change will help create better opportunities for reinvestment and encourage business growth.

We are sharing good news! This article is an update to several previous articles discussing Pennsylvania’s tax treatment of 1031 exchanges and the legislature’s ongoing efforts to recognize 1031 exchanges for its personal income tax.

On July 7, 2022, the Pennsylvania Legislature passed HB 1342, a budget bill that included sweeping tax reform legislation. It was later signed by the Governor and enacted as law. A provision of the Bill conforms Pennsylvania’s Personal Income Tax (“PIT”) laws to mirror federal tax law and provide for the the deferral of gain under Section 1031 in a deferred exchange.[1] This provision will be effective for exchanges commencing after December 31, 2022. The Bill also incrementally lowers the state corporate tax rate from 9.99% to 4.99% over the next eight years. In addition, it increases the limit for Section 179 expense deductions.[2] These provisions will provide a substantial benefit to small businesses, the real estate industry, investors, and their tax advisors.

Benefits of the new legislation for 1031 Exchanges

Prior to the effective date of HB 1342, many small businesses and individuals, including small landlords, were unable to utilize a 1031 exchange (“like-kind exchange”) to defer gain subject to the PIT (3.07% rate). While this may not seem like a large percentage on its face, some taxpayers choose to hold cash out of an exchange in order to pay this liability. Withholding cash from the exchange also triggers a federal tax liability (“boot”).[3]

Preserving more equity creates better reinvestment opportunities – While 3.07% of the net sale price does not sound like much, it’s all relative to the deal size. Even a small amount of equity can go a long way in acquiring replacement property. The corresponding loss of funds reserved for taxes results in a loss of potential leverage. Rental real estate investors can often obtain a loan for two to four times the value of equity used in an exchange, which can help expand the pool of potential replacement properties available. Favorable rates on debt can also increase cash-on-cash returns from the asset. Example: for every $100k in equity leveraged at a 75% LTV it creates an extra $300k in purchasing power.

Parking exchanges will become more practical – Full conformity with federal law should also provide taxpayers with more flexibility to structure reverse and improvement exchanges. Due to Pennsylvania income tax treatment of 1031 exchanges, state real estate transfer tax is applied to title transfers that were part of parking arrangements. Parking arrangements (reverse and improvement) are types of 1031 exchanges that necessitate an accommodator to hold title to one of the properties for a period of time before transferring it back to the taxpayer. This creates a duplicate tax liability because, unlike other states, Pennsylvania currently doesn’t provide an exemption for the transfer of parked property from accommodator to taxpayer.[4] In areas with a local transfer tax in addition to the state, like Philadelphia, Reading, and Pittsburgh, parking exchanges can often be cost prohibitive (i.e., 5% transfer tax + 3.07% PIT = 8.07% liability).

Reduced accounting/administrative burden – State conformity with IRC 1031 will reduce the administrative burden related to accounting for differences between state taxes and federal taxes. This will streamline tax reporting and save money and time for PA investors and real estate partnerships whose ownership includes PA taxpayers.

Summaries of the Bill are linked here:

House Fiscal Note       Senate Fiscal Note

Conclusions

We were optimistic that this issue would finally be resolved because of the strong support that prior bills drew in the Legislature. We applaud the Legislature for fixing this issue and also the industry groups that lobbied for this long-overdue change. Conforming Pennsylvania’s tax code to IRC Section 1031 and in addition, other pro-growth tax provisions will be a boon for small businesses, real estate, and for related industries.

If you would like to discuss your plans regarding a Pennsylvania 1031 exchange, or an exchange in general, please reach out to us at: james@legal1031.com or info@legal1031.com.

[1] Simultaneous exchanges were a possibility under the PIT prior to this legislation. Deferred exchanges were possible for the state Corporate Net Income tax which conforms to federal tax treatment of IRC Section 1031.

[2] The expense deduction limit is increased from $25,000 to $1.08M with a phase out for equipment purchases over $2.5 million. The $25,000 limit was in conformity with the Federal Tax Code in 1997.

[3] Taking cash boot at closing to pay a 3.07% liability in a 1031 exchange is ill advised. At the federal level the cash boot is first taxed as unrecaptured §1250 gain (25%) due to depreciation taken during the course of ownership.

[4] See PA RTT Bulletin 2006-01 discussing Pennsylvania Tax Treatment of 1031 Exchanges prior to HB1342 (2022). We expect that this bulletin will be superseded or revised to accommodate parking structures under the new law.

 

Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary/accommodator to facilitate your exchange.

Disclosure: This to advise you that, unless otherwise expressly indicated, any perceived federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.