Pearlstein v. Commonwealth

323 A.3d 716

James and Karen PEARLSTEIN, Appellants

v.COMMONWEALTH of Pennsylvania, Appellee

Reed and Gail Slogoff, Appellants

v.Commonwealth of Pennsylvania, Appellee

Robert Pearlstein and Cynthia Pearlstein, Appellants

v.Commonwealth of Pennsylvania, Appellee

No. 21 MAP 2023

No. 22 MAP 2023

No. 23 MAP 2023

Supreme Court of Pennsylvania.

Argued: March 6, 2024

Decided: September 26, 2024

Appeal from the Order of the Commonwealth Court at No. 741 FR 2017 dated February 10, 2023 overruling the exceptions and Affirming the August 23, 2017 Order of the Board of Finance of Revenue at Nos. 1624357, 1624358, Renee Cohn Jubelirer, President Judge, Patricia A. McCullough, Anne E. Covey, Michael H. Wojcik, Christine Fizzano Cannon, Ellen Geisler, Lori A. Dumas, Judges

Appeal from the Order of the Commonwealth Court at No. 742 FR 2017 dated February 10, 2023 overruling the exceptions and Affirming the August 23, 2017 Order of the Board of Finance of Revenue at Nos. 1624354, 1624355, Renee Cohn Jubelirer, President Judge, Patricia A. McCullough, Anne E. Covey, Michael H. Wojcik, Christine Fizzano Cannon, Ellen Ceisler, Lori A. Dumas, Judges

Appeal from the Order of the Commonwealth Court at No. 743 FR 2017 dated February 10, 2023 overruling the exceptions and Affirming the August 23, 2017 Order of the Board of Finance of Revenue at Nos. 1624359, 1624360, Renee Cohn Jubelirer, President Judge, Patricia A. McCullough, Anne E. Covey, Michael H. Wojcik, Christine Fizzano Cannon, Ellen Ceisler, Lori A. Dumas, Judges

Joseph C. Bright, Esq., Dan Aaron Schulder, Esq., Heidi Renee Schwartz, Esq., Cozen O’Connor, Matthew Jonathan Meltzer, Esq., David Shechtman, Esq., Faegre Drinker Biddle & Reath LLP, for Appellants.

James Daniel Harrison, Esq., Michelle Ann Henry, Esq., Neil Patrick McConnell, Esq., Michael John Scarinci, Esq., Pennsylvania Office of Attorney General, for Appellee.

TODD, C.J., DONOHUE, DOUGHERTY, WECHT, MUNDY, BROBSON, McCAFFERY, JJ.

OPINION ANNOUNCING THE JUDGMENT OF THE COURT

JUSTICE DONOHUE

This personal income tax case requires the Court to address the timing of the reporting of net gains or income from like-kind exchanges of real property. The case arises out of consolidated appeals from decisions of the Board of Finance and Review ("Board") sustaining the Department of Revenue’s ("Department") personal income tax reassessments against taxpayers for the years 2013 and 2014. The Department reassessed the taxes at issue based on its determination that net gains from the exchange of real property are taxable at the time of the exchange. Reed Slogoff, Gail Slogoff, Karen Pearlstein, James Pearlstein, Robert Pearlstein and Cynthia Pearlstein (collectively "Taxpayers"),¹ partners in real estate purchasing and development partnerships appealed. Based on our careful review of the relevant statutory and regulatory scheme, we conclude that net gains on like-kind exchanges are taxable at the time of the exchange. We therefore affirm the order of the Commonwealth Court.

At all times relevant to the present dispute, the Pennsylvania Tax Reform Code of 1971 ("TRC")² taxed net gains or income from the sale, exchange or other disposition of property as income. 72 P.S. § 7303(a)(3) ("Section 303").³ The gain is recognized in the tax year in which "the amount realized from the conversion of the property into cash or other property exceeds the adjusted basis of the property." 61 Pa. Code § 103.13(a).

As under the TRC, the federal Internal Revenue Code ("IRC") also provides that the gain or loss from a sale of property must be recognized upon the sale or exchange of the property. 26 U.S.C. § 1001(c) (stating that, except as otherwise provided, "the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized[ ]"). However, the IRC provides an exception to this general rule: a taxpayer does not have to report the gain or loss on the exchange of real property where a "like-kind exchange" occurs pursuant to 26 U.S.C. § 1031(a)(1) ("Section 1031(a)"). According to the IRS, a like-kind exchange is "when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or ‘like-kind[.]’ "⁴ First promulgated in 1921 as Section 202(c), the exception has long allowed nonrecognition treatment for exchanges of certain properties. The Revenue Act of 1921, Pub L. No. 67-98, § 202(c), 42 Stat. 227, 230. Now enshrined in Section 1031(a), the exception provides that a gain or loss from the exchange of real property is not treated as a realized gain or loss so long as the real property was "held for productive use in a trade or business or for investment" and "is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment." 26 U.S.C. § 1031(a)(1).⁵ That is, a taxpayer defers realization of the gains or losses for federal tax purposes by exchanging property rather than "liquidat[ing] or ‘cash[ing] in’ on his or her original investment." N. Cent. Rental & Leasing, LLC v. United States, 779 F.3d 738, 741 (8th Cir. 2015). "With a [like-kind exchange,] the taxpayer essentially continues his or her original investment via the like-kind property." Id. (internal citations omitted). Relevantly, the TRC does not explicitly address like-kind exchanges, nor does it reference Section 1031 or the federal income tax deferral rule.

In this case, Taxpayers completed like-kind exchanges of real property in 2007 and 2008 and deferred the gains realized on the exchanges on both their Pennsylvania and federal income tax filings. They timely filed 2013 and 2014 Forms PA-40 for their personal income taxes, which deferred realization and recognition of the gain. After reviewing the tax returns, the Department determined that passthrough entities, in which Taxpayers held an interest, sold property and deferred the net gains from the sale of property as a like-kind exchange. However, the Department interpreted the TRC as treating net gains from the sale, exchange, or other disposition of property as income, and it found no exception allowing deferral for gains on like-kind exchanges. Viewing deferral of the gains as inconsistent with the TRC, the Department issued notices of assessment to Taxpayers, increasing their 2013 and 2014 net gains and assessing penalties and interest.

Taxpayers protested the assessment notices at the Board of Appeals claiming that deferring reporting of gains on the like-kind exchange was permissible under the personal income tax Bulletin 2006-07 (October 20, 2006) (hereinafter "Bulletin 2006-07").⁶ In addressing "Pennsylvania tax treatment of [Section] 1031 like-kind exchanges[,]" Bulletin 2006-07 recognizes that Pennsylvania’s personal income tax does not contain an analogous provision to IRC Section 1031 and indicates that "exchanges of property that result in gain or income are generally subject to tax." Bulletin 2006-07, at 3. Bulletin 2006-07 then provides the following:

However, the Department has determined that gain or loss on like-kind exchanges does not have to be recognized at the time of the exchange if a taxpayer’s method of accounting permits thedeferral of gain from a like-kind exchange. For example, APB Opinion 29 provides for non-recognition of gain or loss on certain like-kind exchanges for taxpayers who consistently use GAAP ⁷ principles of accounting. A taxpayer must use the method of accounting on a consistent basis and the method of accounting must clearly reflect his income. A taxpayer may not change his method of accounting just to obtain a tax benefit for a particular transaction. Nevertheless, the deferral of gain or income associated with like-kind exchanges is the exception.

Id. Taxpayers challenged the assessment notices and requested penalty abatement relying on Bulletin 2006-07. The Board of Appeals denied their claims.

Taxpayers appealed to the Board. Taxpayers challenged the Department’s calculation of their taxes, arguing that their taxable income is "computed using the method of accounting regularly used in keeping the taxpayers’ books." Pearlsteins’ Board Decision, 8/29/2017, at 2 (citing 72 P.S. § 7303(a.1)) and 61 Pa. Code § 101.2). Their view was that the determination of net gains from disposition of property in a like-kind exchange is a function of the taxpayers’ method of accounting. They insisted that Bulletin 2006-07 and PA Schedule C both affirm that theirs is an acceptable accounting method. Id. The Department responded that the Federal Income Tax ("FIT") method of accounting is not an acceptable accounting method for Pennsylvania personal income tax purposes. The Department asserted that any contrary reading of Bulletin 2006-07 notwithstanding, the TRC prohibits deferral. Id. at 3.

The Board reversed the assessment of penalties but otherwise agreed with the Department. Pearlsteins’ Board Decision, 8/29/2017, at 4. It observed that the Commonwealth imposes a personal income tax on eight classes of income, one of which is net gains or income from disposition of property. Id. at 3 (citing 72 P.S. §§ 7302(a), 7303(a)(3)). Further, it acknowledged that the TRC identifies acceptable methods of calculation in Section 303 and in personal income tax regulations. 72 P.S. § 7303 (a.1) (providing that income shall be computed under the taxpayers’ regularly used method if it clearly reflects income or under a method which "clearly reflects income"); 61 Pa. Code § 101.2 (providing, inter alia, that no method of accounting is prescribed but that the method must "clearly reflect income"). Finally, the Board recognized that, contrary to its current position, the Department published guidance on like-kind exchanges in Bulletin 2006-07 that "it will not require a taxpayer to realize gain on an exchange ‘if a taxpayer’s method of accounting permits the deferral of gain from a like-kind exchange.’ " Pearlsteins’ Board...