By Dan A. Schulder, CPA, JD, LLM

Internal Revenue Code Section 1031 permits taxpayers to defer paying tax on gain for federal income tax purposes when they invest in real estate and exchange one property for another property. Practically every state has expressly conformed to this rule, usually with a statute that provides that the state has conformed to federal law. In Pennsylvania, whether or not taxpayers can defer gain pursuant to Section 1031 for state personal income tax purposes has been contested for years.

The taxpayers in Pearlstein v. Commonwealth prepared their books and records using “accepted accounting principles and practices” applying the federal income tax method under other comprehensive basis of accounting (OCBOA). In reliance on the statutory scheme, the Pennsylvania Department of Revenue’s (DOR) regulation, and its then published bulletin, the taxpayers deferred the gain realized from the exchange of real estate located in Pennsylvania in the 2013 and 2014 tax years. Though they followed the statute, regulation, and the DOR’s guidance in effect at the time, the DOR disallowed the gain deferral and assessed personal income tax (PIT) on the deferred gain. The taxpayers appealed to the state Supreme Court, and the case was heard on March 6, 2024.

Background

When the PIT was adopted in Pennsylvania in 1972, the legislature specifically enacted provisions that allowed for basis of accounting either under generally accepted accounting principles (GAAP) or OCBOA. It allowed for these bases of accounting to be used via the definition of “accepted accounting principles and practices” in Sections 301(a) and 303(a)(3) of the PIT Code.¹

OCBOA is not GAAP, but it does provide an acceptable basis to report financial conditions that fairly present the financial position of the business and is an informative and comprehensive financial reporting structure. Acceptable OCBOA methods include the cash basis of accounting, the modified cash basis of accounting, the statutory basis of accounting, and the federal income tax basis of accounting (FIT method).

In 2022, the Pennsylvania legislature specifically included Section 1031 into the PIT Code effective for tax years beginning after Dec. 31, 2022. Prior to that time, without an express incorporation of Section 1031 by statute, taxpayers who exchanged properties and deferred gain for federal income tax purposes had to rely on the existing statutory scheme and the guidance of the DOR for authorization to defer gain for PIT purposes.

Since its adoption in 1972, the PIT Code allowed the deferral of gain under certain circumstances through the use of the accounting method adopted under either GAAP or OCBOA. The PIT Code requires taxpayers to adhere to a method of accounting that applies these accepted principles and practices, which are acceptable by the accounting profession and which are not inconsistent with regulations of the DOR setting forth such principles and practices. The DOR published regulations, which are almost as old as the PIT Code itself, that mirror the statutory definition of “accepted accounting principles and practices.” The DOR expanded on that definition, stating that it shall presume a method of accounting clearly reflects income, if that method is consistently used, reflects generally accepted accounting principles and practices in the taxpayer’s business, and is used for federal income tax purposes.² It was the DOR’s stated position in nonbinding published guidance until 2017 that taxpayers who consistently used the FIT method of accounting could defer gain for PIT purposes.³

The Arguments

In oral argument in Pearlstein v. Commonwealth before the Pennsylvania Supreme Court, the Commonwealth relied heavily on the statutory change in 2022, and argued that Section 1031 permits gain to be deferred indefinitely, effectively permitting a taxpayer to avoid paying tax on gain realized until or past their death. According to the Commonwealth, if a taxpayer is permitted to defer gain for Pennsylvania PIT purposes, it will be permitted to file its Pennsylvania PIT return without accounting for any differences between the IRC and the Pennsylvania PIT Code.

The Commonwealth also argued that GAAP is the only generally accepted method of accounting that the legislature intended for PIT taxpayers to use to defer gain while maintaining a method of accounting that clearly reflects income. However, the Commonwealth was hard pressed to respond to the inquiries posed by the Supreme Court as to the meaning of “accepted accounting principles and practices” and the language related to GAAP and OCBOA, including the FIT method.

The Supreme Court questioned whether the legislature intended the term “accepted accounting principles and practices” to mean GAAP, and scrutinized the language of DOR’s regulation. The Supreme Court considered that GAAP is a method of accounting primarily applied by publicly traded companies, not individual taxpayers and small business owners subject to PIT, and reasoned that an interpretation of DOR’s regulation that only permitted gain deferral if a taxpayer used GAAP would be detrimental to small businesses. The Supreme Court also considered the practical considerations of the Department of Revenue’s position. The Supreme Court raised the logistical problem that, if a taxpayer can defer gain for federal income tax purposes but not for Pennsylvania PIT purposes, he or she would be expected to pay PIT on gain without having cash in hand to pay the tax since the property was exchanged and not sold.

What’s to Come

The decision from the Supreme Court will be a test as to whether the DOR can effectively ignore the language of its own statute and corresponding regulation. The decision, when rendered, will affect taxpayers across Pennsylvania who have also challenged the DOR’s position in tax years prior to 2023. It will also have strong repercussions for accountants in preparing a taxpayer’s financial statements, who may no longer be able to rely on the DOR’s published guidance to prepare financial statements⁴ that can be reliably used by lenders of such taxpayers or to prepare Pennsylvania PIT returns.

¹ 72 P.S. Sections 7301(a) and 7303(a)(3).
² 61 Pa. Code Section 101.2.
³ See PIT Bulletin 2006-07.
⁴ This specific point was raised by the PICPA in its amicus brief filed with the Commonwealth Court on exceptions.

Dan A. Schulder, CPA, JD, LLM, is a member with Cozen O’Connor in Harrisburg, Pa. His practice includes all aspects of federal, state, and local taxation, as well as other areas. He can be reached at dschulder@cozen.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}