State (Finally) Recognizes 1031 State Tax Deferral

By: Michael L. Solomon and Steven M. Williams

Effective January 1, 2023, commercial and investment real estate sellers in Pennsylvania, for the first time, can defer personal income tax from a sale—conforming with the existing Federal IRC §1031 (1031 Exchange). With the passage of House Bill 1342 (Act No. 53 of 2022) in July 2022, Pennsylvania became the final state in the union to recognize 1031 Exchanges as a vehicle to defer state income taxes.

The Evolution of the 1031 Exchange:

• The earliest form of a legislatively approved 1031 Exchange appears in the federal Revenue Act of 1921, which was intended to provide relief to taxpayers through a deferral strategy with the hopes that they would continue to reinvest.
• In 1954, an amendment to the Federal Tax Code placed the tax deferral process in Section 1031; that amendment also adopted the current definition and description of a tax-deferred like-kind exchange.
• In the face of litigation on the subject, Congress enacted further clarification and imposed more-structured requirements for 1031 Exchanges through the Deficit Reduction Act of 1984.
• A “reverse exchange” was a concept added in 2000 with the issuance of Revenue Procedure 2000-37.
• Revenue Procedure 2002-22, adding an additional replacement property option that previously did not exist, sparked significant growth in 1031 Exchange volume that continues to this day.

A 1031 Exchange allows tax on the capital gain from real property to be postponed or deferred if the proceeds are reinvested in a similar property as part of a qualifying “like-kind exchange.” In Pennsylvania, this now means that gains resulting from a qualifying exchange of real property may be tax-deferred—NOT tax-free—for state personal income tax, as it is for federal tax purposes.

Consider this simple example: a Pennsylvania real estate owner purchased a corner drug store for $1 million many years ago and now has the opportunity to sell that corner for $2 million. Doing so under the pre-House Bill 1342 format, the sale would have resulted in a $1 million gain for the seller, for which they would have been subject to pay state personal income tax. If the seller chose to pay the tax out of the sale’s proceeds, moreover, they would have triggered the federal tax and technically voided their opportunity to take advantage of the 1031 Exchange tax treatment. Now, however, if this transaction were to occur after January 1, 2023, the seller would be able to defer all taxes on the gain.

The advantages from a 1031 Exchange are numerous, including: immediate tax deferral; increased cash flow (the money retained by not having to pay state tax is instead utilized to invest in replacement real estate); growth of real estate portfolios; business expansion and business growth; and benefits for retirement strategies.

Real property owners who wish to take advantage of this new Pennsylvania opportunity are cautioned to enlist the assistance of real estate and tax professionals who are experienced in 1031 Exchanges as IRC § 1031 imposes strict and somewhat complex requirements for the proper and timely “relinquishment” of existing real property and acquisition of a qualifying “replacement” property. The following are among the basic technical time constraints in proceeding with a successful 1031 Exchange:

• 45-day Identification Period. A taxpayer has 45 days from the date of sale of the relinquished property to identify potential replacement property.
• 180-day Completion. A taxpayer must acquire all replacement property before 180 days from the sale of the relinquished property or the federal tax return due date for the year in which the exchange commenced.

Cohen Seglias’ Business Transactions Group works with qualified intermediaries who serve as fiduciaries for the exchanger and attend to the creation and completion of an exchange, and its attorneys are fully equipped to provide competent representation in the 1031 Exchange process.

Michael L. Solomon concentrates his practice in the areas of real estate, administrative law, creditors’ rights, commercial transactions, and corporate finance. Clients rely on him for guidance and legal services in business law and estate planning and administration. Mike can be reached at msolomon@cohenseglias.com or 717.480.5303.

Steven M. Williams provides a full range of legal services to help his clients avoid and resolve legal problems and maximize the success of their businesses. He concentrates his practice on commercial litigation, real estate, landlord and tenant law, condominium and homeowner law, employment law, construction, and business and corporate law. Steve can be reached at swilliams@cohenseglias.com or 717.480.5302.