Pennsylvania court overrules taxpayers’ exceptions regarding net gains on like-kind exchanges

The taxpayers were partners in several real estate development and management partnerships and used the federal income tax (“FIT”) method of accounting. The taxpayers had asserted that, for Pennsylvania purposes, net gains on like-kind exchanges should be taxed when the property is sold since such deferrals are allowed under IRC § 1031. The court had previously affirmed the Board's decision that net gains on like-kind exchanges should be taxed in the years the transactions occurred since (unlike IRC § 1031) the Pennsylvania Tax Reform Code (“TRC”) did not allow tax deferrals on net gains from like-kind exchanges of real property.

The court overruled the taxpayers' contention that the court failed to strictly construe the TRC statute² in the taxpayers' favor when this statute imposes a tax.

The court observed that the principle that statutes imposing taxes and statutes exempting persons or other property from taxes should be strictly construed should only apply when the statutory language is ambiguous. The court stated it found no ambiguity in the statutory language of Section 303(a.1) of the TRC.

Instead, the court interpreted the plain language of the statute to permit the Pennsylvania Department of Revenue to assess PIT on net gains from the taxpayers' like-kind exchanges when the exchanges were made, because the FIT method of accounting did not clearly reflect income as defined under the TRC.

Mazars’ Insight

Note that as a result of the 2022-2023 Pennsylvania state budget agreed to by Governor Tom Wolf and the Pennsylvania State Legislature on July 8, 2022 (reported in a prior Mazars SALT Alert), Pennsylvania conforms to the nonrecognition rules of Section 1031 for transactions that occur in tax years beginning after December 31, 2022. Prior to this change, the nonrecognition rules of Section 1031 were not applicable for purposes of Pennsylvania personal income tax, as affirmed in this court case.

State income tax laws should always be considered when contemplating a Section 1031 like- kind exchange. Some states may not tax a like-kind exchange, when executed, but will tax the sale of the replacement property even if the replacement property is not located in the specific state where the original property was located. For example, several states (California, Massachusetts, Montana and Oregon) have adopted “claw back” provisions.

Capital gains taxes at the federal and state level will continue to be deferred until the exchanged property is sold, at which point any capital gains will be taxed at the federal level as well as at the state level (if there is state income tax where the new property is located). However, if the original relinquished property was located in one of the aforementioned states, state income tax will likely be owed on the capital gains in these states as well.

Please contact your Mazars professional for additional information.

^{1. James and Karen Pearlstein, Petitioners v. Commonwealth of Pennsylvania, Respondent Reed and Gail Slogoff, Petitioners v. Commonwealth of Pennsylvania, Respondent Robert Pearlstein and Cynthia Pearlstein, Petitioners v. Commonwealth of Pennsylvania, Respondent CASES CONSOLIDATED No. 741 F.R. 2017 No. 742 F.R. 2017 No. 743 F.R. 2017.}

^{2. Pa. Stat. Ann. Title 72 § 7303(a)(1).}

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.