Pennsylvania Supreme Court Rules: Pennsylvania Did Not Conform to IRC 1031 Exchanges for Individuals Prior to 2023

The Pennsylvania Supreme Court recently issued a significant ruling in Pearlstein v. Pennsylvania. The court determined that, for tax years prior to 2023, Pennsylvania did not conform to “like-kind” exchanges under Section 1031 of the Internal Revenue Code for personal income tax purposes.  

This means that taxpayers involved in like-kind exchanges during those years were required to pay Pennsylvania income tax to the state in the year that the like-kind exchange occurred, even if gain recognition was deferred for federal income tax reporting purposes.  

Key Points from the Ruling on Pearlstein v. Pennsylvania 

In upholding the assessment against the taxpayers in Pearlstein, the Pennsylvania Supreme Court observed that Pennsylvania’s Tax Reform Code (TRC) does not expressly or implicitly adopt the Internal Revenue Code. It defines taxable income for Pennsylvania personal income tax purposes. Before 2023, the TRC lacked a provision deferring gain from like-kind exchanges. 

The individuals in Pearlstein owned interests in five limited partnerships that bought, sold, developed, and managed commercial and residential real estate. In 2013 and 2014, those partnerships engaged in like-kind exchanges of real property, and consistent with Section 1031, the individual partners’ federal and Pennsylvania personal income tax returns deferred the recognition of gain from the transaction.  

The Pennsylvania Department of Revenue audited the taxpayers’ 2013 and 2014 personal income tax filings and assessed them for tax liabilities on the grounds that the applicable Pennsylvania tax law did not incorporate Section 1031 or have a similar state-specific provision. The taxpayers unsuccessfully protested the assessment to the Board of Appeals and then to the Commonwealth Court before appealing to the Pennsylvania Supreme Court. 

The taxpayers’ argued that their Pennsylvania personal income tax returns were consistent with the Department’s guidance in Bulletin 2006-07, which explained that Pennsylvania will not require taxpayers to recognize gain from Section 1031 exchanges “if a taxpayer’s method of accounting permits the deferral of gain from a like-kind exchange.” The Department countered that the Department’s tax regulations require the taxpayers to use a method of accounting that “clearly reflects income” and that the taxpayers’ “federal income tax” method of accounting was inconsistent with the TRC and the Department’s regulations, and that Bulletin 2006-07 was ambiguous as to which methods of accounting would permit the taxpayers to defer the gain from the like-kind exchange. 

The Department had updated Bulletin 2006-07 in December 2017 to explain that Pennsylvania does not contain a provision analogous to Section 1031 for personal income tax purposes, and that “Section 1031(a) cannot be used as a basis to defer gain from the exchange of properties for Pennsylvania [personal income tax] purposes.”   

What Is the Pearlstein v. Pennsylvania Ruling?  

The Pennsylvania Supreme Court determined that the tax regulation requiring taxpayers to use a method of accounting that “clearly reflects income” trumps the ambiguity in Bulletin 2006-07. Accordingly, the Department’s regulations require the taxpayers to recognize the gain from the IRC 1031 exchange for Pennsylvania personal income tax reporting purposes.  

Key Takeaways from Pearlstein v. Pennsylvania  

• Individuals who engaged in like-kind exchanges in Pennsylvania before 2023 should review their Pennsylvania personal income tax filings because they may have potential tax exposures.
• In general, provisions that impose a tax are construed in favor of the taxpayer, while provisions granting an exemption are strictly construed against the taxpayer. A dissenting opinion in Pearlstein explained the regulations regarding which accounting methods “clearly reflect income” is a provision that imposes a tax and, therefore, the regulation’s ambiguity regarding the identification of acceptable accounting methods should be resolved in favor of the taxpayers and the assessments should be nullified.
• The Pennsylvania Supreme Court determined that the law change adopting Section 1031, effective starting 2023, cannot be applied retroactively. It is important to note that the same court reached a different conclusion in Synthes, where it determined that the law change in 2014 could be applied to prior years. The disparate treatment of the two law changes creates uncertainty regarding tax compliance. 

The Pearlstein v. Pennsylvania ruling has significant implications for taxpayers who engaged in like-kind exchanges in Pennsylvania prior to 2023. Understanding the nuances of state tax laws is important for maintaining accurate tax filings and avoiding penalties. Connect with our team below for customized advice.