The napkin test boils down complex 1031 tax concepts into an easy to understand set of rules of thumb that help you decide if you’re going to defer all of your gains in a 1031 exchange. The napkin test sets up three benchmarks that must be satisfied in a 1031.
The first benchmark of the napkin test is value. When you’re doing a 1031 exchange you need to have a continuation of investment into a new, bigger, better property. Imagine if you sold a property for a million dollars and acquired only a $10K replacement property. The surly IRS agent would look at you cross eyed and say:
“Hey, where’s your continuation of investment here? You’re $990k short of equal or greater value replacement property.”
So the first benchmark if you want to defer the tax is to acquire a replacement property of equal or greater value. Going up in value fixes a lot of problems that can occur from a tax perspective.
The next benchmark is equity. If you bought a million dollar replacement property but only reinvested $10K of proceeds (putting $990K in your pocket), again the IRS agent will say
“Hey, where’s your reinvestment of the equity. I see $990K in your pocket. We’re going to make you pay taxes on that.”
In order to satisfy the napkin test all of your net proceeds need to be reinvested into the replacement property. So we need to redeploy the equity instead of putting it in your pocket.
The last benchmark is debt. Imagine you pay off a $500k mortgage at the sale of your relinquished property and you’re taking the debt backpack off for the first time in years. That debt relief will trigger gain in your 1031 exchange unless you offset that debt relief by either taking out new debt of an equal or greater amount or by reinvesting cash out of your own pocket into the replacement property.
If you win the lottery on the way to closing on your replacement property, you could pay cash for the replacement property. That new cash-in will offset the debt relief dollar for dollar. Most taxpayers don’t win the lottery on the way to the closing and have to take on new debt on their replacement properties.
Here’s a hypothetical:
- We sell a property for a million dollars
- We pay off $500K of debt
- We net $500K in proceeds
If we buy a replacement property for 2 million dollars so we’ve gone up in value, we offset the debt relief of $500k with a 1.5 million dollar mortgage. We also redeploy all of our $500K proceeds. We have satisfied the napkin test by going up in value, equal in equity, and we’ve offset our debt.
- 1031 Hotline: If you have questions about the napkin test, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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