Most states allow investors to defer state taxes, but there are some distinct outliers that should be noted by both exchange professionals and real estate investors. One state in particular that is different from the rest is Pennsylvania.
Pennsylvania is a major outlier in that the state does not recognize section 1031 at all. Meaning that at the time property is sold in Pennsylvania, the owner must pay applicable state taxes on the sale. Pennsylvania is also unique in that this tax rate is flat across all tax paying entities regardless of income level or ownership type. According to the state’s tax help website, “Pennsylvania personal income tax is levied at the rate of 3.07% against taxable income of resident and nonresident individuals, estates, trusts, partnerships, S corporations, business trusts and limited liability companies not federally taxed as corporations.” In addition to this income tax, the state also imposes a real estate transfer tax of 1%. And many municipalities in the state also impose a deed transfer tax of additional 1% on top of that. That means that selling real estate in Pennsylvania will likely incur a tax bill to the seller of 5.07%. And even if the seller is conducting a 1031 exchange, they will likely have to pay that either way.
It’s not all bad news for Pennsylvania real estate investors, however. First and foremost, they can still conduct a 1031 exchange and defer federal capital gains tax. In 2020 the top federal tax bracket was 20%. Also the 3.8% net investment income tax can be deferred as well. So, while a Pennsylvania real estate investor does have to pay 5.07%, they can still defer as much as 23.8% in taxes. Another bonus is that there will not be a depreciation recapture tax charged to the investor. This tax is typically 25% on the portion of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property.
So, while Pennsylvania is not the ideal state to own property from a tax perspective, there are still tools available to owners of Pennsylvania real estate who wish to reduce their tax burden. One thing a Pennsylvania real estate investor might consider is conducting a section 1031 exchange into a property that is out of the state and in a location with more favorable tax consequences. An investor who is not familiar with out of state real estate could accomplish this by purchasing a professionally managed DST property.
For more information on different state’s tax treatment of 1031 exchanges, or how to find suitable replacement property in another state, contact one of our 1031 exchange specialists today!
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