Pennsylvania Conforms its State Tax Code to Federal §1031
By: James T. Walther, Esq., LL.M.
General Counsel, Legal 1031 Exchange Services, LLC
Updated 1/2/2023 – this law is now effective for 1031 exchanges where property is relinquished in 2023.
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 federal 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. Moreover, 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 into law. A provision of the Bill conforms Pennsylvania’s Personal Income Tax (“PIT”) laws to mirror federal tax law and provide for 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, and will promote real property investment in Pennsylvania.
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] This change benefits residents and non-residents who own Pennsylvania real estate.
Preserving additional equity creates better reinvestment opportunities – While 3.07% of the net sale price does not sound like much, it is 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 2-4 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 might become more practical – Pennsylvania’s full conformity with federal tax law may also provide taxpayers with greater flexibility to structure reverse and improvement exchanges. Due to Pennsylvania’s longtime non-recognition of 1031 exchanges for its personal income tax, the state real estate transfer tax is also applied to transfers that were part of parking arrangements. Parking arrangements (reverse and improvement exchanges) are forms of 1031 exchange 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 structure creates a potential duplicate tax liability because, unlike other states, Pennsylvania transfer tax laws currently do not 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 transfer tax, like Philadelphia, Reading, and Pittsburgh, parking exchanges can often be cost prohibitive (i.e., 5% aggregate transfer tax).
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 relevant parts 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 correcting this issue and appreciate 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 1031 exchange in Pennsylvania, or a 1031 exchange more generally, please feel free to contact James T. Walther, Esq., L.L.M. by email at james@legal1031.com or info@legal1031.com.
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[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 (revised September 27,2022) discussing Pennsylvania Tax Treatment of 1031 Exchanges. We anticipate that in the future, this bulletin may be superseded or revised with respect to the transfer tax issues to reflect changes in the law. See also Realty Transfer Tax Bulletin 2008–01
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