Taxpayers transacting a 1031 exchange involving real estate located in Philadelphia, or who are located in Philadelphia should be aware of the City’s tax treatment of 1031 exchanges. On September 15, 2022, the Philadelphia Department of Revenue issued guidance clarifying the city’s approach to the tax treatment of Internal Revenue Code Section 1031 Exchanges. This pertains to the Business Income and Receipts Tax (BIRT) and Net Profits Tax (NPT).” This is particularly notable as Pennsylvania did not recognize Section 1031 for personal income tax (“PIT”) purposes until 2023, unlike other states. ¹

State Tax Treatment of IRC §1031: In general, Pennsylvania is one of several states that selectively conforms to changes made by Congress to the federal tax code. Starting in 2023, Pennsylvania aligned its Personal Income Tax with IRC Section 1031, facilitated by HB 1342, a budget bill enacted on July 7, 2022. As a result, PA taxpayers selling real estate starting in 2023 and utilizing a 1031 exchange can defer capital gain at both federal level and income subject to the PIT (a 3.07% rate). ² Under current law, corporations can defer recognition of capital gains from real estate sales for state Corporate Net Income Tax, which typically aligns with federal tax principles. Here is a link to a short article on the topic.

An Overview of Philadelphia Business Taxes: Philadelphia has two separate income taxes that might apply to business entities and individuals selling real estate located in Philadelphia.³ Linked here is an overview and chart courtesy of the City of Philadelphia.

1. 1. The Business Income Receipt Tax (BIRT) is a tax on the income of any business enterprise or activity in Philadelphia, including a real estate rental business, active or passive, big or small. This includes individuals, LLCs (single member or multimember), partnerships, corporations, and trusts.

“There are two components of the BIRT:

• • • Tax on Net Income, which is based on the income a business generates in Philadelphia,

 and

• • • Tax on Gross Receipts, which is based on receipts from sales made and/or services performed in Philadelphia.”

• • • • “The first $100,000 of taxable Gross Receipts are excluded from BIRT.”

An Overview of Philadelphia Business Taxes

Philadelphia imposes two separate income taxes that could affect business entities and individuals involved in real estate transactions within the city:

1. 1. Business Income Receipt Tax (BIRT): Applies to all business activities in Philadelphia, including a real estate rental business, active or passive, big or small. The BIRT applies to individuals, LLCs (single member or multimember), partnerships, corporations, and trusts.

Includes two components:

• • • Tax on Net Income, based on the income generated in Philadelphia.
    • Tax on Gross Receipts, based on sales or services performed in Philadelphia. The first $100,000 of taxable Gross Receipts are exempt from BIRT.

1. 2. Net Profits Tax (NPT): Targets the net profits from any business operated by the taxpayer. Applies to unincorporated entities, like LLCs, Trusts, and partnerships that have not elected corporate tax status. This includes non-resident businesses transacting sales or otherwise operating in Philadelphia.

* Partnerships and individuals generally must report both the BIRT and NPT. To prevent a double taxation issue, a taxpayer subject to both the BIRT and the NPT can credit up to 60% of the tax paid for the Net Income component of the BIRT.

Philly DOR Guidance: The new DOR guidance cleared up an accounting question and will help taxpayers who are transacting a 1031 exchange plan accordingly.

“Philadelphia tax treatment of IRC § 1031 transactions The City of Philadelphia does not have an ordinance that specifically adopts IRC §1031 treatment for the non-recognition of capital gains on the sale or exchange of like-kind property. Both the Philadelphia Code and Revenue Department regulations are silent as to this specific federal statute. To the extent that it is not required under the Philadelphia Code, the Department of Revenue will not recognize IRC § 1031 on like-kind exchanges.”

Philadelphia DOR Guidance 2022

The recent guidance clarifies that the BIRT can be calculated using one of two methods and the taxpayer’s previous election to calculate their taxes using one method versus the other matters for purposes of a 1031 exchange:

Under “Method I”: IRC §1031 cannot be utilized due to BIRT Regulation 403 stating that the rules for determining taxable net income for Net Income Method I align with those for the NPT. Guidance for Net Profits Tax (NPT) The NPT considers federal income realized on a real estate sale, regardless of whether the gain is recognized within the same tax year, meaning the tax deferral benefits of IRC Section 1031 are not available. ⁴

Under “Method II”: If a taxpayer elects to report net income using this method and utilizes IRC §1031 for federal taxable net income calculations, it must be followed for BIRT calculations. This includes deferring gain under Section 1031, which would not be included in the BIRT calculation. ⁵

The NPT considers federal income realized on a real estate sale, regardless of whether the gain is recognized within the same tax year, meaning the tax deferral benefits of IRC Section 1031 do not apply.

“Net Gain is defined under Income Tax Regulation 101(h) as cash, credit, property, remuneration, or consideration that is realized (emphasis added) after allowance for all expired costs and expenses which are ordinary, necessary, and reasonable as measured in accordance with a cash or strict accrual accounting system. Net gain shall include the disposition of assets occurring as part of the normal operations or termination of the business (emphasis added).”