Why don’t all states recognize 1031 real estate exchanges?
When advisors have clients looking to sell property in order to reinvest the proceeds to purchase more property, there are certain taxation laws they must consider.
Each state in our union handles state taxation of 1031 exchanges differently, as each state has its own requirements pertaining to state tax withholding, clawback rules, filing deadlines and other aspects of an exchange.
Sometimes, as in the case of California regarding clawback provisions, certain states stand out for their treatment of a particular issue. Whenever a state handles a particular issue in a unique way, this should always be noted carefully by 1031 professionals, because the way in which an issue is handled by one state can quickly become adopted by other states across the nation. California, for instance, has always been seen as a sociopolitical trend-setter, so its treatment of 1031 exchanges at the state level should catch the eye of qualified intermediaries, 1031 attorneys and other professionals involved in the 1031 industry.
Pennsylvania has long been seen as something of an oddity given its pronounced reluctance to recognize 1031 exchanges. If a taxpayer conducts a 1031 exchange involving the sale of a Pennsylvania state property, that taxpayer will incur a tax liability to the state of Pennsylvania, regardless of whether the taxpayer acquires either a Pennsylvanian or non-Pennsylvanian property. In this article, we’ll look at the specifics of Pennsylvania state taxation as it applies to real estate; explore the reasons underlying Pennsylvania’s position toward exchanges; and hypothesize whether we can expect other states to follow Pennsylvania’s example.
PENNSYLVANIA'S TAXATION OF REAL ESTATE
Whenever there is a disposition of real estate within Pennsylvania, the disposition will constitute a taxable event. This is true regardless of whether the disposition was part of a Section 1031 exchange. Currently, Pennsylvania has a personal income tax rate of 3.07%; this rate is flat so it applies to all income levels. Simply put, if a taxpayer conducts an exchange involving a Pennsylvanian property, he or she will need to budget for this additional flat tax. Importantly, only your gain will be used in the computation of your personal income, and your gain derives from your sales price minus your adjusted basis. Fortunately, there is no need to worry about any additional depreciation recapture at the state level in Pennsylvania.
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On top of this flat personal income tax to the state, those selling a piece of Pennsylvanian real estate should also be aware of Pennsylvania’s real estate transfer tax (also referred to as Pennsylvania’s “realty transfer tax”). Pennsylvania’s realty transfer tax consists of a 1% tax on the gross sales price of the real estate; most municipalities within the state also place an extra deed transfer tax on the disposition of real estate, so most sales within Pennsylvania will generate a 2% transfer tax. The state may also impose two sets of realty transfer taxes on 1031 exchanges that involve parking title to real estate; this is because, technically, such parking transactions require that title be formally transferred between separate entities. For instance, in a reverse 1031 exchange, a specialized LLC, or “exchange accommodation titleholder” (EAT), temporarily holds title to the property while the taxpayer’s original property is sold; because title is transferred in this manner, these transactions may lead to double realty transfer taxes.
EXPECTATIONS FOR THE FUTURE
Pennsylvania’s reasoning behind its position on 1031 exchanges is both mundane and thought provoking at the same time. On the one hand, Pennsylvania imposes its flat personal income tax rate on these transactions for the simple reason that it needs the revenue.
Though 3.07% may not seem huge to the casual observer, on large real estate transactions it can produce sizable liabilities, and this revenue is undoubtedly useful for public services and projects. However, as per its official statement on 1031 exchanges from the Pennsylvania Department of Revenue, the state also has another reason for its treatment of Section 1031: Pennsylvania state officials see delayed or deferred exchanges as legal fictions, so these officials see no reason why such transactions shouldn’t produce taxable consequences at the state level. In their view, exchanges that require a third party or facilitator to complete, which includes all exchanges aside from direct swaps between two parties, are not “true” exchanges, so logically it follows that the state should not remove taxation from such transactions.
At the present time, Pennsylvania is one of just a few states that don’t recognize Section 1031 and impose a state income tax on such transactions, regardless of whether the taxpayer certifies that the transaction is part of a tax-deferred exchange. How likely is it that Pennsylvania’s position will spread to other states? Given the wide range of fiscal issues plaguing the many states of our union, there is a real possibility that Pennsylvania’s model may be imitated by other state governments, but putting an exact figure on the probability is difficult. Pennsylvania’s reasoning regarding non-direct swap exchanges is certainly interesting, and may be potentially persuasive when examined by other state officials.
In tough financial times, such reasoning may well be sufficient to convince a few other states that the deferral benefits of Section 1031 should be confined to federal taxation.
Fortunately for taxpayers and 1031 professionals, however, the vast majority of states have consistently recognized the provisions of Section 1031 at the state level, and inertia can be a powerful force to be reckoned with. States typically collect other kinds of taxes on Section 1031 transactions — such as transfer taxes — so they’ve found other ways to benefit from these deals beyond personal income taxes. Pennsylvania’s position is definitely something to consider.
If nothing else, it’s proof that state governments can latch onto nearly any reason when trying to ensure their revenues remain as robust as possible. We will just have to wait and see how many other governments follow suit.