On September 27, 2022, the Pennsylvania Department of Revenue (“DOR”) issued a revision of Personal Income Tax Bulletin 2006-07 (the “Bulletin”), which confirms that recent Pennsylvania legislation reversed longstanding caselaw that disallowed deferral of gain recognition for like-kind exchanges. Under Act 53 of 2022, the Commonwealth now conforms with section 1031 of the Internal Revenue Code (“IRC 1031”) for Pennsylvania income tax purposes.
Under general income tax principles, when property is sold for a profit, the seller must pay tax on the gain recognized from the sale. IRC 1031 provides an exception to this general principle, however, when two parties exchange similar or “like-kind” real property that is used for business or held as an investment. For example, if Party A owns Building 1 and Party B owns Building 2, rather than selling the buildings and having to pay tax the year the sales occur, A and B can exchange the buildings to one another and defer the gain recognition and tax owed.
The DOR’s Bulletin provides that like-kind exchanges will now be given similar treatment in Pennsylvania for tax years beginning after December 31, 2022.
However, the Bulletin also makes clear that this deferral of gain applies only in the context of income tax. Pennsylvania taxpayers who engage in like-kind exchanges after 2022 will still be required to pay sales and use tax and transfer taxes, as applicable, for each transfer.
This is noteworthy because under IRC 1031, a like-kind exchange does not have to occur simultaneously if certain requirements are met (“Deferred Exchanges”). Said differently, taxpayers can acquire the replacement party before divesting the relinquished property, and vice versa, yet still qualify for IRC 1031’s tax-deferred treatment. Sometimes an additional party, such as a Qualified Intermediary or Exchange Accommodation Titleholder, can help facilitate like-kind exchanges (a “Facilitating Party”).
Use of Deferred Exchanges, Facilitating Parties, or both can be very useful for taxpayers interested in divesting old property and acquiring new property via a like-kind exchange, but cannot find a counterparty to conduct an exchange with.
Returning to our example, with A and B. Suppose A was not interested in Building 2, but B wanted to acquire Building 1. Through careful planning and implementation, A and B could conduct a Deferred Exchange with a Facilitating Party (“FP”) where A and B divest Buildings 1 and 2, respectively, to FP. Then, FP conveys Building 1 to B. FP continues to hold title of Building 2 until A finds desirable replacement property. This can still qualify as a like-kind exchange under IRC 1031, and now, the Bulletin.
Now suppose C owns Building 3 but wants to divest it in order to acquire Building 2. Under the right circumstances, FP can help structure an exchange where C transfers Building 3 to FP and FP transfers Building 2 to C, all the while still qualifying for tax-deferred treatment under IRC 1031. Also, if A wanted to acquire Building 3 from FP, this could possibly qualify as well upon satisfying particular requirements.
As mentioned above, Pennsylvania conforms to IRC 1031 only for income tax purposes. The Bulletin explains sales and use taxes and transfer taxes would still apply to scenarios with multiple transfers, such as the one described above. This further necessitates the use of careful planning with skilled professionals for anyone who is contemplating a like-kind exchange.
If you have any questions regarding like-kind exchanges for Pennsylvania income tax purposes, please contact any member of the McNees State and Local tax team to discuss.