Real estate moguls and investors are not only savvy investors but also diligent in monitoring the tax implications of buying and selling their properties. In a decision by the 9th Circuit in 1979, the power of the tax-deferred exchange of properties was born. Section 1031 of the Internal Revenue Code (“IRC” or the “Code”) offers a significant tax planning tool for investors because it provides an exception to the rule that gain must be recognized on the sale or exchange of real property when certain qualifying property is exchanged for other qualifying property that is like kind. Under Section 1031 of the IRC, no gain or loss is recognized on the exchange of real property held for either: (1) productive use in a trade or business; or (2) investment. If proper criteria and procedures are followed, the investor will not realize a gain on the exchange and will receive a carryover basis in the replacement property. This carryover basis will preserve any built-in gain in the relinquished property.
For years, Pennsylvania did not recognize a 1031 Exchange for Pennsylvania income tax purposes and only recognized the IRC 1031 for federal income tax purposes. This recent change comes from the adoption of House Bill 1342, signed by Governor Wolf on July 8, 2022, which will go into effect on January 1, 2023, a date all real estate investors are closely watching.
Prior to this enactment, real estate investors were unable to utilize a 1031 Exchange to defer gain subject to the Pennsylvania Personal Income Tax 3.07% rate. Pennsylvania was the only state in the nation that did not provide a state tax benefit to tax-deferred exchanges. While this rate may seem minuscule, many taxpayers would elect to hold cash out of an exchange to pay this liability. By holding cash from the sale, additional federal tax liabilities are being triggered and ultimately defeating the entirety of the purpose of a 1031 Exchange.
This recent adoption by Pennsylvania will conform with the federal 1031 Exchange under the IRC and will provide the following benefits: reduced accounting and administrative burdens, preserve more equity and create better reinvestment opportunities. Again, 3.07% of the net sales price seems ministerial, but everything is relevant to the deal size. This former loss of funds reserved for taxes was causing a loss in potential leverage. The conformity between state and federal tax codes will now be streamlined for tax reporting and save time and money for Pennsylvania investors and real estate partnerships in 2023. The streamlined process, along with the added buying leverage, will increase the pool of replacement properties available for purchase which only helps to further the revitalization of real estate in the state of Pennsylvania.
1031 Exchanges are a critical tool for encouraging investment, building wealth, and creating jobs for the state of Pennsylvania. Like any exception, 1031 Exchanges require an acute attention to detail and provide a procedure that must be strictly followed. As an investor, you need to ensure you are well-informed on this most recent legislation in order to follow the necessary steps to further strengthen your tax planning tools.