1031 exchanges are common in most of the United States. They give property investors an opportunity to roll capital gains over into new investments, offering deferred taxes when they do.
Unfortunately, the state of Pennsylvania didn’t recognize 1031 exchanges in the past; however, that’s changing. Starting in 2023, Pennsylvania residents will finally be able to take advantage of the tax deferral that comes along with a 1031 exchange.
Find the details of 1031 exchanges, what the news means for Pennsylvania residents, and the benefits of 1031 exchanges below.
What is a 1031 Exchange?
A 1031 exchange is a process based on section 1031 of the United States tax code. Under this section, owners of property held for business or investment purposes may defer the realization of capital gains from property sales by reinvesting the proceeds from the sales into new properties of like kind. “Like-kind” simply refers to the intended use as a business or investment property - not the actual type of real estate.
This means if you purchase a home for $150,000, sell it for $400,000, and use that $400,000 to purchase another piece of business or investment real estate, you can defer the $250,000 in capital gains realized through the sale of the original property.
Pennsylvania hasn’t recognized this tax deferral in the past, consequently charging state income tax on realized capital gains from real estate regardless of what the investor did with the funds.
What This Means for Pennsylvania Residents
The announcement that Pennsylvania will begin allowing 1031 exchanges in 2023 is great news for Pennsylvania residents on a state tax and federal tax level. As mentioned above, when a property investor sold a property in Pennsylvania in the past, they would have to pay state taxes on the capital gains they realized regardless of what they did with the money after the sale.
As a result, many investors used proceeds from the sale of real estate to pay state taxes, but that caused a problem on a federal level.
In a 1031 exchange, all proceeds must be re-invested in a like-kind investment. Since Pennsylvania residents often used proceeds from sales to pay state taxes, they didn’t qualify for a 1031 exchange on a federal level either.
Now that Pennsylvania allows these exchanges, Pennsylvania residents can not only take advantage of state tax deferrals, but they can also take advantage of federal tax deferrals.
Benefits of a 1031 Exchange
There are several benefits of taking advantage of a 1031 exchange. Some of the most important include:
- Immediate tax deferral on capital gains and depreciation recapture.
- With less of a tax burden, investors have more purchasing power when reinvesting funds.
- Real estate investors can use the 1031 exchange rule to preserve the values of their estates as their heirs receive the assets on a stepped-up basis.
- The 1031 exchange also offers business owners a solid retirement exit strategy.
Investors have been taking advantage of section 1031 since lawmakers added it to the United States tax code over a century ago (1921). Unfortunately, the Pennsylvania tax code did not allow residents to take advantage of the benefit if they used their real estate proceeds to pay state taxes. As Pennsylvania begins to allow 1031 exchanges, residents in the state can now take advantage of this significant tax haven.