For many years, Pennsylvania has been one of the few states that did not recognize like-kind exchanges (also known as 1031 exchanges or land swaps). Now, with the passing of Act 53 of 2022 by Governor Wolf, Pennsylvania finally has adopted 1031 exchanges. This change may lower your tax burden on real estate transactions and even encourage more investment in the state.
What is a Like-Kind Exchange?
A like-kind exchange is a strategy under the Internal Revenue Code to exchange property of the “same nature, character, or class” without paying federal income tax. The type of property usually doesn’t matter as all real estate is considered like-kind to each other so long as it’s located in the United States of America. For example, an investor may want to sell her residential rental to purchase an apartment building or an office building.
Before President Trump passed the Tax Cuts and Jobs Act of 2017 (which is due to sunset in 2025), you could exchange real property, personal property, and intangible property. Under current law, however, you may only exchange real estate as part of a 1031 exchange.
If you complete a like-kind exchange correctly, you will reduce or eliminate your obligation to pay federal income taxes from the exchange. However, these taxes do not just disappear.
Instead, the IRS will re-assign the basis (the monetary value of your property for tax purposes) of your Relinquished Property to the Replacement Property. Thus, the downside to completing a like-kind exchange is that this does limit your depreciation options on the Replacement Property. The taxation is only deferred until you sell the Replacement Property.
But only your federal income tax was deferred; you still had to pay state taxes on the exchange. A federal SALT deduction could somewhat limit the state tax impact, though. A SALT deduction permits a deduction on a taxpayer’s federal income tax return for certain taxes paid to states and municipalities.
The Tax Cuts and Jobs Act also kneecapped this deduction and changed its cap from previously almost unlimited to just $10,000. Investors certainly hope that when this law sunsets in 2025, legislators will reinstate an increase in the SALT deduction.
What did Act 53 change?
Before Act 53, a Pennsylvania taxpayer only had deferred federal income tax, not state. The entire state income tax was required to be paid for the Relinquished Property sale, though, as explained previously, they could deduct some of the state tax with the SALT deduction. This caused significant taxpayer concern and limited outside investment from other states, especially for heavily depreciated properties or those with a high sale value.
For example, an exchange of a farm for $2 million with a basis of $200,000 would result in approximately $55,000 in state income taxes. If a taxpayer reserved that $55,000 from the exchange, it would result in a boot to the taxpayer and require federal income taxes to be paid for the money earmarked for state taxes. This is not an ideal situation.
Now, if you sold that same property, there would be limited or no Pennsylvania income tax on the same transaction so long as you abide by the rules and regulations for the exchange.
Where do I start?
To take advantage of a 1031 exchange, you must follow specific requirements under the IRS Code. For a forward exchange (the most common type), you need to
- Hire a Qualified Intermediary (a “QI”), which is sort of like an escrow agent, before the sale of the property you are exchanging (the “Relinquished Property”)
- Sell the Relinquished Property while the QI holds the funds from that sale in an account separate from your assets
- Identify a Replacement Property or Properties in 45 days in writing to the QI
- Purchase a Replacement Property within 180 days from the date of sale of the Relinquished Property
With the passing of Act 53, Pennsylvania finally decided to recognize 1031 exchanges (like-kind exchanges on property, presumably only real property at the moment). The language is very brief, and it’s not certain if Pennsylvania will provide its own regulations that deviate from mostly settled federal laws on the subject.
But at least for now, one impediment to investment in Pennsylvania has been removed.
As this article is a summary, it does not fully describe the ins and outs of how to complete a 1031 exchange, nor does it offer any advice on other types of 1031 exchanges, such as reverse exchanges. If you wish to learn more, please get in touch with RKG’s office and schedule a consultation regarding your options for a like-kind exchange.