The journey to finalizing a 1031 exchange can be complex and full of twists and turns. It might involve some rough and rocky paths with a nagging suspicion that one wrong turn will cost you. Fortunately, seasoned tax advisors and qualified intermediaries have distilled the requirements for a fully tax-deferred exchange into a simplified framework known as the “Napkin Test.”
The Napkin Test
it’s called the “Napkin Test” because these three rules are so fundamental you could jot them down on the back of a napkin during lunch and you’d be well on your way to understanding the essence of a successful 1031 exchange.
Rule One: Trade Up in Value
Your goal when doing a 1031 exchange is typically to defer all capital gains taxes. To achieve that goal, the value of your replacement property should be of equal or greater value when compared to the value of your relinquished property. In other words, if you sell a property for $1 million (after subtracting certain qualifying transactional expenses such as commissions, legal fees, transfer taxes, title charges, and recording fees that reduce the amount realized on the sale), your next purchase must cost at least $1 million. (See IRS Revenue Ruling 72-456 and Letter Ruling 8328011 for a more extensive list of qualified transactional costs that may also be able to be deducted from the gross sale price to reach the amount realized.)
Think of this as the price tag rule. Trading down in value, even by a little, means you’ll likely recognize taxable gain on the difference. In tax-speak this is known as “boot.”
Rule Two: Trade Up in Equity
It’s not just about the total purchase price. You also need to roll forward all your equity. That means reinvesting every dollar of net proceeds from your sale into your replacement property.
If you pocket some of that cash or use it to cover costs not considered part of the exchange, you’ve created a cash boot and that portion of your gain is taxable. It’s like running a relay: if you drop the baton (your equity), you’re out of the race for full deferral.
Quick math check: Equity = Sales Price – Qualified Transactional Expenses – Mortgage Payoff
Rule Three: Offset Any Debt Relief
Here’s where things get a little trickier. If you had a mortgage on the relinquished property, you can’t simply walk away from that debt and expect full deferral. You must replace that debt by either taking on new debt that is of equal or greater value than the replacement property or contributing additional cash to cover the gap in value.
Failing either, or some combination thereof, will result in mortgage boot which is another way the IRS collects taxes when an exchange isn’t structured properly.
Putting It All Together: The Napkin in Action
Let’s say you sell an investment property for $1 million with $400,000 in debt and $600,000 in equity. With the goal of deferring all capital gains taxes, you will need to:
- Buy a new property worth at least $1 million
- Reinvest the full $600,000 equity
- Offset the $400,000 debt with either new financing or more of your own cash
Miss one of these steps and the IRS is waiting with a calculator.
A Note for Accountants (and the Tax-Curious)
While the “Napkin Test” offers a digestible overview, here’s the more technical version:
- Value Analysis: Trading down in value (net of the qualified transactional expenses) triggers recognition of gain to the extent of the decrease.
- Equity Analysis: Any equity not reinvested (or used to pay qualified transactional costs) becomes taxable boot.
- Debt Relief: Unreplaced debt is treated like cash received and may trigger taxable gain.
Importantly, your new tax basis on the replacement property generally equals its fair market value minus the deferred gain.
New Basis = Fair Market Value of Replacement – Deferred Gain
Final Thought: The Simplicity is Deceptive
Like all good rules of thumb, the “Napkin Test” is a starting point and not the whole story. Every 1031 exchange is nuanced, and while these three rules will keep most investors on the right path, the devil (and the IRS) is in the details.
Working with a knowledgeable qualified intermediary is essential to navigating the twists and turns and smoothing the path for a successful 1031 exchange. We won’t just bring a napkin; we’ll bring the whole table.
Jeff Peterson is a Minnesota attorney and former adjunct professor of tax law. He serves as President of Commercial Partners Exchange Company, LLC, where he facilitates forward, reverse, and build-to-suit 1031 exchanges nationwide. Jeff regularly collaborates with attorneys, accountants, and real estate professionals on exchange strategies. Reach him at 612-643-1031 or [email protected] or on the web at www.cpec1031.com.
