Pennsylvania will finally grant the tax deferral benefit of 1031 like-kind exchanges beginning in 2023. What does that mean for real estate professionals and their clients?
A 1031 exchange allows the seller of business use or investment property to defer the gain when exchanging for another business use or investment property. An exchange is much like the sale of one property followed by the purchase of another linked together by paperwork completed within a certain period of time. What makes the old property and new property “like-kind” is its use not the property type. Any type of property used in a trade or business or held for invest will qualify for 1031 tax-deferral treatment.
An exchange is allowed under Section 1031 of the federal tax code, but the tax deferral is not allowed in the commonwealth. Act 53 was signed by Gov. Tom Wolf on July 8 and finally brings 1031 recognition to Pennsylvania effective Jan. 1, 2023.
Thanks to the advocacy efforts of the Pennsylvania Association of Realtors®, 1031s were included in legislation this year. Pennsylvania Realtors® have been urging support for 1031s for several years, as the commonwealth was the only state in the country with an income tax regime that did not allow them.
“There’s a misconception that 1031 like-kind exchanges are just for commercial properties, but in reality, every residential Realtor® probably sells a rental property that may be eligible for a 1031,” said Margo McDonnell, president and CEO of 1031 Corp., Collegeville, Pennsylvania. “The other misconception is that 1031s are difficult. Real estate professionals don’t need to worry about the details of the 1031, that’s the job of the 1031 exchange qualified intermediary. The Realtor® just needs to make their clients aware that a 1031 might be something they want to consider and focus on getting their client to the closing table.”
While real estate professionals should be aware of the possibility of 1031s, they should be directing their clients to talk with an expert, reminds PAR’s Chief Legal Officer Hank Lerner. “A Realtor® should not be directing a client on whether or not they should be pursuing a 1031 exchange. They should let their clients know a 1031 may be a possibility, but that the client should contact their tax consultant to determine how to accomplish their investment goals,” Lerner said.
And clients need to consider whether a 1031 is applicable before getting to the closing table, McDonnell noted. “We get calls from people all the time after the closing has occurred, asking about 1031s, and it’s too late at that point. Clients are extremely frustrated then because they weren’t made aware that a 1031 was a possibility. The exchange can be initiated anytime up until at the closing of their relinquished property,” she said.
There are several benefits of 1031 exchanges:
- Immediate tax deferral.
- Time value of the tax deferral.
- Greater buying power.
- Increased cash flow.
- Consolidation of properties.
- Relocation or expansion of a business.
- Estate preservation.
- Retirement exit strategy for business owners.
Craig Fernsler, CCIM, a commercial Realtor® and senior director at KW Commercial in Blue Bell, has been advocating for 1031 exchanges to be adopted in Pennsylvania for years.
“This is great news for many of my clients and investors in Pennsylvania. This change should help increase investment and redevelopment activity back into in Pennsylvania as opposed to other states. So many clients have had to hold money back from their property sale to pay the state taxes, but with the adoption of 1031 exchanges, this money will be able to be reinvested back in our communities.”
Fernsler noted, “This change is really a huge benefit to both commercial and residential investors.”
PAR’s Immediate Past President Christopher Raad said, “I’m really proud of PAR’s legislative effort to get 1031s approved in Pennsylvania. Recognizing 1031 is a fantastic incentive for buyers interested in investing in the commonwealth, who may have previously opted to invest in another state because of the tax benefits.”
Chichi Ahia, secretary of the Society of Industrial and Office Realtors® Philadelphia Chapter and the executive director, principal and broker of record of SVNI Ahia Commercial Real Estate in eastern Pennsylvania, views the 1031 like-kind exchange as critical and applauds PAR’s legislative efforts.
“I don’t think many people realize how critical they are to the engine of the real estate market and the economy. They are probably the single leading, motivating factor for decision making on when to sell, what to buy and how to replace property. It’s a pretty significant part of our business.”
He said, “As an example, we had a client last year who was attempting to sell a property and execute a 1031 exchange but for a variety of reasons, they weren’t able to and as a result, had to pay a significant (seven-figure sum) in taxes because they couldn’t execute the 1031. These funds represent dollars that weren’t able to be reinvested in the community. Each deal cycle like this creates a number of additional economic benefits for various communities, beyond the deal itself.”
Tommy Songer, CCIM, PE, owner of Centre CRE in State College, said, “The fact that Pennsylvania now allows the 1031 tax treatment in the sale of commercial properties is great news for owners, developers and in my case, family CRE portfolios. My family has been involved in commercial real estate for many years and has used the federal 1031 like-kind-exchange benefits to reposition and diversify our portfolio when the right opportunity presented itself.”
He continued, “One thing we always had to consider however, was the state tax hit on capital gains when we sold a property, especially properties that we’ve owned for many years and thus had a sizable, realized capital gain upon sale. Sometimes the state tax hit would tilt us into a ‘no-go’ decision, and we would not buy the property. Or if we did go through with a deal there was less money available to improve the next property or project. I’m sure the new tax law allowing the deferral of state taxes on capital gains will incentivize more deals, make more money available for property improvements and, in the case of properties along Pennsylvania borders, draw investment into the state that wouldn’t otherwise come, because Pennsylvania now offers the same tax advantages as all other states in the country.”
Songer said PAR’s and members’ perseverance paid off. “I applaud PAR and those who worked so hard over the past five years to educate our state legislators about the benefits of instituting 1031 exchange tax treatment and helping them to understand that this will be a great help in making Pennsylvania more competitive in attracting investment, as well as benefitting the local communities where investment will now take place where it otherwise might not have,” he said.
Realtors® can learn more about like-kind exchanges at NAR.Realtor.
Register online to attend PAR’s webinar, “The Basics of 1031 Like-kind Exchanges,” at 10 a.m. on Monday, Aug. 22 featuring Margo McDonnell and PAR President Christopher Beadling.