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Pennsylvania’s Sec. 1031 Treatment

IRC Section 1031 applies to federal income taxation of capital gains. This means that an investor’s federal capital gains receive deferral treatment regardless of where he or she resides. However, the nonrecognition treatment of Section 1031 doesn’t necessarily apply to state taxation. Pennsylvania’s Sec. 1031 treatment is a case in point. We’ve discussed this on our blog before: state taxation is an additional layer of complexity in 1031 like kind exchanges. States which have their own income tax are free to either acknowledge or ignore the provisions of Sec. 1031, as they see fit. Some states, such as California, recognize the provisions of Sec. 1031, but pursue out-of-state sales with a clawback law.

Fortunately, most states accept the nonrecognition treatment of Section 1031 and do not impose income taxes on exchanges. In most cases, states simply require that taxpayers fill out a form to avoid the state tax withholding. These forms notify the state that there is a Sec. 1031 transaction and that the gains are deferred. There are a few notable outliers, however. Pennsylvania’s Sec. 1031 treatment is perhaps the biggest anomaly among states in its treatment of like kind exchanges.

In this post, we will discuss Pennsylvania’s Sec. 1031. As we will see, Pennsylvania has its reasons for not recognizing the deferral treatment of this IRC section. It’s important that we understand Pennsylvania’s reasoning on this issue, because the policy of one state can quickly become the policy of another. Our great State of New York, for instance, could easily adopt Pennsylvania’s stance at some point in the future. So let’s take a look at Pennsylvania’s position in detail.

Pennsylvania’s Sec. 1031 & Delayed Exchanges as Legal Fictions 

Pennsylvania doesn’t recognize the provisions of IRC Section 1031 in its own tax law. Owners of Pennsylvania real estate who sell their property must report all gains on Pennsylvania’s income tax form. In this way, the Commonwealth stands out in its tax treatment. As mentioned, almost all states in our union recognize Section 1031’s deferral provisions. Some states, such as Washington State, don’t have state income tax and so for those states, it’s an non-issue. For those states which do collect income taxes, most impose a withholding requirement on real estate sales. This ensures that these states receive the income tax from the sale. However, this requirement can be suspended in a Sec. 1031 exchange through the filing of a withholding certificate. 

Pennsylvania’s Sec. 1031 Rationale

Pennsylvania’s reasoning underlying its stance is based on its interpretation of Section 1031’s purpose. Specifically, when Sec. 1031 was initially created, it was meant to be a vehicle used to defer taxation of reciprocal exchanges. Reciprocal exchanges are the “direct swap” exchanges we’ve discussed previously. Direct swap exchanges involve only two parties: the taxpayer and the party who holds the replacement property. In this exchange, the taxpayer literally trades properties with the other party. The taxpayer has the property the other party wants, and vice versa. These exchanges were quite common when Section 1031 was in its early years. But over time, these exchanges became less and less common. Today they are, by far, one of the least common types of exchanges used.

Basically, Pennsylvania sees direct swap exchanges as having a rational foundation, but not delayed exchanges. The Commonwealth of Pennsylvania sees non-reciprocal exchanges as legal inventions which have allowed taxpayers to defer gains which should be recognized. As a consequence, Pennsylvania does not recognize IRC Section 1031 for state income tax purposes.  

Pennsylvania Imposes Income Tax on All Real Estate Transactions 

If a taxpayer sells a Pennsylvania property, he or she will be subject to Pennsylvania personal income tax. The current personal income tax rate for Pennsylvania residents is 3.07%. Residents will therefore be liable for 3.07% on whatever gain they recognize from a sale. Let’s look at a quick example. Suppose a PA resident sells a PA property for $1 million with a basis of $500,000. This $500,000 gain is then taxed by the Commonwealth at the rate of 3.07%, which equals a liability of $15,350. Pennsylvania residents will need to plan ahead for this liability. 

Pennsylvania’s Transactional Tax

Pennsylvania also imposes a transactional tax on real estate sales. This is referred to as the realty transfer tax. This consists of a 1% tax on the gross sales price of the real estate. Most local districts within Pennsylvania also charge another, separate transfer tax on top of the Commonwealth’s transfer tax. And so most transactions within the Commonwealth will generate more than 1% for the transfer tax. Again, taxpayers within Pennsylvania need to budget for this additional cost. 

Not Likely to Have Much of a Following

It’s not likely that other states will follow the Pennsylvania example. But it’s still very important that we understand the example and know that it could potentially be followed at any time. Many states are struggling to balance their budgets and bring in as much revenue as possible. It’s conceivable, though not highly probable, that some states may consider revising their view toward IRC Section 1031 as they seek more funds. We’ve seen that our own great State of New York has struggled with many concerns relating to the state budget. We hope that our stance on 1031 remains the same for the foreseeable future, but there’s no guarantee.

Get Tax Attorney Help!

Here at Mackay, Caswell & Callahan, P.C., we understand the value of keeping up with state and national tax trends. If you don’t stay up with trends, you can be overwhelmed by them when they rise and gain momentum. This type of attitude is a top quality to look for when seeking a tax attorney. If you need tax assistance, feel free to contact one of our New York City tax attorneys right away!

Image credit: Shinya