Client Alert: 1031 Exchanges Prior to 2022 Subject to PA Tax

The following is an important alert for those who completed a like-kind exchange of real estate in Pennsylvania prior to 2022 and deferred the gains on their tax return(s). Pennsylvania did not follow the same gain deferral rules as the IRS under IRC Sec. 1031 during years prior to 2022, when Pennsylvania amended its Tax Reform Code to align with federal tax treatment.  The recent Pennsylvania Supreme Court case of James and Karen Pearlstein et al. v. Commonwealth of Pennsylvania may subject 1031 exchanges taking place prior to 2022 to Pennsylvania income tax.

In James and Karen Pearlstein et al. v. Commonwealth of Pennsylvania, the Pennsylvania Supreme Court ruled that a group of real estate partners must pay personal income tax on gains from like-kind exchanges. The partners in Pearlstein had deferred gains from like-kind exchanges on both federal and state tax returns and argued that deferral was the proper tax treatment under the Pennsylvania Tax Reform Code. However, the Pennsylvania Supreme Court concluded that Pennsylvania law at the time did not permit deferral, and the Pennsylvania Department of Revenue was correct in assessing taxes and penalties for the tax years at issue (2013 and 2014). The Pennsylvania Supreme Court explained that gains from like-kind exchanges were taxable under the Pennsylvania tax code even if, for U.S. federal income tax purposes, the gains were deferred under IRC Sec. 1031. The Pennsylvania Supreme Court concluded that under Pennsylvania’s Tax Reform Code prior to 2022, net gains from the sale or exchange of property were required to be reported and taxed, with no exceptions for like-kind exchanges. The Pennsylvania Supreme Court made it clear in Pearlstein that:

The 2022 amendment to the Pennsylvania Tax Reform Code allowing deferral on like-kind exchanges is not retroactive and does not apply to transactions completed before 2022.

This ruling serves as an alert for real estate investors who engaged in like-kind exchanges prior to 2022. If you deferred gains on such exchanges in Pennsylvania for years prior to 2022, you could face potential reassessments, penalties, and interest, given the Pennsylvania Department of Revenue views those gains as taxable. It is important to consult with a tax professional to review your filing history and assess any potential tax exposure that may exist stemming from this recent decision.   The tax attorneys at Obermayer are available for consultation on this issue to help you assess your potential liability.

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This alert is intended to notify its readers of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.