Want an easy way to know if you satisfy the requirements of your Exchange? Welcome to the Napkin Test. The Napkin Test was literally conceived on a napkin at a seminar by California tax attorney Marvin Starr of Miller, Starr and Regalia. It’s a simple exercise to determine the potential for exposing taxable assets or “boot” in an Exchange. The Napkin Test compares the values of the relinquished and replacement properties.
You may offset mortgage boot with cash, but you cannot offset cash boot with additional mortgage. Boot is “unlike” property received in an Exchange. Cash, personal property, or a reduction in the mortgage owed after an Exchange are all potentially boot and subject to tax.
Although it doesn’t replace a detailed Exchange recapitulation worksheet, the Napkin Test can quickly and easily assess an Exchange and any potential for boot. Tune in below as we walk through examples, and how use them in our video update!
David Moore: Hello David Moore with Equity Advantage, 1031Exchange.com, and we’ve been getting lots of confusion or questions on what is required to fully satisfy a 1031 Exchange with respect to value and equity. We call this the napkin test, and probably one of the largest misunderstandings in our industry is the statement you must replace debt in an Exchange.
So 1031 is not all or nothing. So what I mean by that is you don’t have to defer all your gain, you can choose to defer any portion of it, and in order to be fully tax deferred, you must go across or up in value and equity between the relinquished and the replacement properties and that could be one property into one property, it could be 10 properties into one, it could be one into 10 different properties, it really doesn’t matter. But you’re looking at the aggregate value and equity of all properties being relinquished and the aggregate value of all properties being on the acquisition side, and really, like I said, it’s not all or nothing, every dollar you spend more on something than you want cost you a buck, if you don’t spend it, maybe it’s 30 to 40 cents, depending on what your tax bracket is and what’s happening in that transaction.
David Moore: But I’ve had people literally say, “Well gee, should I pay more for this property, than what I’ve agreed to because I’m gonna have some tax exposure.” And the answer to that question is an absolute no, and once again, I wanna stress that the misunderstanding on debt that’s been stated wealth. I’ve been in this business for 30 years, I’ve been wrestling with people being told that the full 30 years, and it’s one of those things, debt can go away two ways. Debt can go away by going down in value, which is gonna trigger tax because you went down in value, the other way debt goes away is by adding cash.
So right now, I’m speaking to you, it’s September of 2021, and the markets are screaming along right now, but at some point we’re gonna have an erosion, and at that point in time, we talk about tangible assets, inflationary hedges a little bit, we’ll talk a little bit more about that later, but the reality is, if you give a piece of property today, your loan-to-value, everything is out, there is gonna be a little different if you have a recessionary period of time, typically, you’re gonna have a reduction in equity, you’re gonna have a reduction in loan-to-value of what’s available out there, and so inevitably people will ask me because they’ve been told incorrectly through the years, well, you can’t have a reduction in debt.
David Moore: And so they say, “Well, gee, should I have to pay down the property pre-disposition if I can’t have that loan-to-value on acquisition, or maybe I can’t get a loan on acquisition,” and the answer to that question is an absolute no. You can always show up at the replacement property closing with the additional cash that’s needed, you can reduce that debt or totally eliminate that debt if you’re off setting a reduction in debt with additional cash into the transaction.
So we like to say you can offset mortgage boot or reduction in mortgage with cash, you cannot offset cash boot with additional mortgage. So once again I wanna stress, it’s always possible to add cash into a transaction, and in recessionary times, it’s pretty much a necessity to get it done, and it’s not gonna trigger a problem for you. I hope this has cleared it up for you.
David Moore: Once again, across or up in value and equity, that’s what’s important, and I guess one last statement I’d like to make is those value and equity numbers are gonna be adjusted by normal transactional costs. So you’re gonna back out brokers commissions, title escrow fees, tax and legal fees, our fees, maybe current property tax proration, those things are all gonna be reductions of that sales price, and they also reduce your net equity by a corresponding them out, and none of those things should trigger any tax exposure as boot received.
Now, there are other things that could, maybe you’re paying for the buyer’s closing costs, maybe you’ve got lender required repairs. Some of these things are not gonna be considered normal transactional costs, it’s gonna ultimately result into different tax treatment with different tax professionals, so these are conversations you’re gonna wanna have with your tax people.
David Moore: If you or they have questions, don’t hesitate to give us a call we’re happy to discuss it, but once again, I just wanna add a little clarity to this much asked question and something that has lot of false information out there on. So David Moore, Equity Advantage, 1031Exchange.com, and thank you for the time today. Take care. Best of health. Bye-bye.
Measured from when the relinquished property closes, the Exchangor has 45 days to nominate (identify) potential replacement properties and 180 days to acquire the replacement property. The Exchange is completed in 180 days, not 45 days plus 180 days.
The sooner you involve the team of professionals at Equity Advantage in your 1031 Exchange, the better. They’re seasoned experts who know all the ins and outs of this complicated transaction. Call them at 503-635-1031. and protect your investments!
