By: James T. Walther, Esq., LL.M.
Exchange Director, Legal 1031 Exchange Services, Inc.
As we begin 2019, Pennsylvania is still the only state that does not fully recognize I.R.C. Section 1031 tax deferred exchanges because it does not follow federal taxation principles for its Personal Income Tax (“PIT”). The Pennsylvania legislature had sought to change that issue during the 2017-18 legislative session; however, their efforts fell short, despite strong support for recognizing 1031 exchanges. PA House Bill 331 (“the Bill”), introduced on February 6, 2017, died in the state Senate Finance Committee after it was passed in the PA House by an overwhelming majority of 188-2 on April 10, 2018. The Bill, which was part of legislation entitled the “Small Business Tax Fairness Package” was intended to make PA laws more friendly towards small businesses. The Senate did not pass a reciprocal version of the Bill before the end of the legislative session and the Bill has expired without becoming a law.
Therefore, while exchangers can defer their federal capital gains tax liability, they still must pay Pennsylvania’s personal income tax of 3.07% (if not taxed as a corporation – PA follows federal tax principles for its Corporate Net Income Tax). Until December of 2017, limited circumstances existed in which an individual taxpayer could recognize a 1031 exchange at the state level. One limited circumstance was outlined in Pennsylvania PIT Bulletin 2006-07 (October 20, 2006), before it was revised on December 21, 2017 (the PA Dept. of Revenue revised it, after losing an appeal regarding a GAAP taxpayer’s non-recognition of PIT on capital gains in a 1031 exchange). Prior to revisions, the PIT Bulletin used an example that demonstrated that a taxpayer consistently using GAAP (“generally accepted accounting principles”) as its method of accounting, as opposed to the federal method of taxation, could defer recognition of gain on an exchange, if permitted by its method of accounting. The administrative revision to the PIT Bulletin closed the door on this possibility after the original Bulletin was used as the basis of the adverse decision. The current PIT Bulletin also explains the realty transfer tax (“RTT”) implications of using a qualified intermediary (“QI”) in a forward/deferred exchange or an exchange accommodation titleholder (“EAT”) in a reverse or parking exchange. Also of note is that the exchanger may not be able to defer local taxes on business income such as Philadelphia’s Business Income Receipts Tax (“BIRT”) or Net Profits Tax (“NPT”) because the city follows state law.
If Pennsylvania finally recognizes 1031 exchanges, it would be a major victory for taxpayers and the 1031 industry. The ability to defer PA PIT in an exchange could be a deciding factor for small companies or individuals looking to buy or sell real estate in PA. Legal 1031 is closely monitoring Pennsylvania’s efforts to pass new 1031 legislation and we will keep you updated if there are any major developments. Taxpayers considering a 1031 exchange should always consult with their tax and legal advisors regarding the merits of an exchange and its tax and business planning implications.
Legal 1031 Exchange Services, Inc. is not able to provide tax or legal advice, nor can it make any representations or warranties regarding the tax consequences of your transaction. Property owners must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article 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.
(ii) Compare current Bulletin 2006-07 (revised December 21, 2017)
(ii) PA Tax Update No. 123, October/November 2006
(iii) According to the Bulletin, a QI or EAT is not an agent or a straw party of the taxpayer under Pennsylvania law, therefore; two title transfers may occur in exchanges where the QI or EAT holds title to exchange property.