Legendary California real estate attorney Marvin Starr likely had no idea when he snatched up a paper table napkin during a real estate seminar to jot down some quick 1031 exchange math that he was pioneering the most simple method of determining an exchangor’s financial position in a potential exchange.
Starr, who died in 2019, was widely regarded as a foremost expert on real property law in the Golden State. He co-authored the Miller & Starr, California Real Estate Digest, which is the most widely used and oft-cited real estate case law publication in use throughout the State of California.1
Let’s take a closer look at how the napkin test works and how you can use it as a rough guide to determine if you’ll expose yourself to taxation in a potential 1031 exchange.
The napkin test is a quick and simple method of determining where you stand in a 1031 exchange transaction in regard to asset value, equity, and debt. If your goal is to avoid paying any capital gains taxes in a potential exchange, you’ll want to trade across at a minimum, or up, to avoid creating a taxable event.
Here’s an example of how the napkin test can help you determine where you might end up in a 1031 exchange. Grab a sheet of paper (or a napkin, if it suits you) and follow along with your current investment property and a suitable replacement asset.
|
|
Original Asset |
Replacement Asset |
|
Value |
$3 million |
$4.5 million |
|
Equity |
$1 million |
$1 million |
|
Mortgage |
$2 million |
$3.5 million |
Remembering the “equal or up” rule, you can see here that the exchangor in this example is trading up in both fair market value and mortgage debt, so there is no taxable boot created in this exchange.
But let’s say the investor reduced the mortgage debt in the replacement asset. Any loan amount under the original $2 million would result in a taxable mortgage boot. It’s the same with equity – the exchangor cannot improve his financial position in the exchange, so he must rollover the entire $1 million in equity or pay taxes on any amount less than the full $1 million.
Investors can, if they want, offset any mortgage boot in an exchange by adding cash to the deal. If the new loan was for $1.9 million, the exchangor can add $100,000 of cash to avoid paying any taxes from mortgage boot. However, equity must be a dollar-for-dollar match; you can’t increase the replacement property’s loan amount to offset any equity taken out of the exchange.
It doesn’t take a scientific calculator and mastery of advanced algebraic functions to determine your financial position in a 1031 exchange. A simple napkin test provides a head-to-head comparison of the value, equity, and mortgage debt of your relinquished and replacement asset to show if you will expose yourself to any taxable boot in the deal.
The napkin test should be used as a rough guide only. Conducting a more detailed analysis of a potential exchange with a certified accountancy professional can help solidify your 1031 exchange strategy and ensure the whole exchange qualifies for tax-deferred treatment.
1 Marvin Starr of Miller Starr Regalia Leaves Behind a Vast Legacy, GlobeSt.com, https://www.globest.com/2019/12/17/marvin-starr-of-miller-starr-regalia-leaves-behind-a-vast-legacy/?slreturn=20230411140526