Who Created the Napkin Test?
The Napkin Test was originally created by California tax attorney Marvin Starr on an actual napkin during a conference for real estate investing. The napkin test is an easy way to determine the potential for revealing taxable assets or “boot” in a Section 1031 exchange and to help real-estate investors make better decisions.
What is the Napkin?
The “Napkin” Test compares the values of the relinquished and replacement properties. It is simply a matter of determining if the exchangor is trading across or up in fair market value, mortgage, and equity. If the exchangor trades across or up in the fair market value of each of these three categories, there is no taxable boot related to the 1031 exchange.
This certainly does not take the place of the calculations to determine if any portion of the 1031 exchange is considered taxable; however, it is a way quick way to assess which portion, if any, may be subject to federal and state income tax. Let’s take a look at a quick example.
The Exchangor’s current property is “1” and the property to be acquired is “2.”
Property 1 (current)
Property 2 (to be acquired)
Here, the Exchangor is trading up in fair market value, across in equity, and up in mortgage; therefore, there is no taxable boot.
What is “Boot” in a 1031 Exchange Mean?
The boot is any ‘unlike’ property received in a 1031 exchange. Property such as personal property, cash, or a reduction in the mortgage securing the property owed after an exchange is all “boot” and subject to federal (and sometimes state) income tax. By being able to forecast the potential for taxable boot, an investor is able to rethink the structure of the 1031 exchange before committing to the deal.
In the above example, if the investor were to trade their relinquished property (Property 1) with a mortgage of $1,350,000 for the replacement property (Property 2) and, instead of a $1,750,000 mortgage, Property B was subject to a $900,000 mortgage, the incremental $450,000 would be subject to federal income tax as taxable ‘boot’. This doesn’t necessarily mean that the 1031 exchange would not qualify for tax deferral treatment. Rather, tax deferral is still achieved except for the taxable ‘boot’ portion of the exchange.
An investor can use the Napkin test to quickly ascertain whether there may be any portion of their 1031 exchange that could be subject to federal income tax. While this is a good exercise for investors to go through, we still recommend consulting a tax professional to perform the necessary calculations and analyze the exchange to confirm the findings using the Napkin test.
Reported on Form 8824
This will also be reported to the IRS on your federal income tax return on Form 8824 (to IRS.gov). You can think of this form as an expansion of the Napkin test. It will report any taxable portion of the 1031 exchange, the new basis in the property exchanged into, etc. While a 1031 exchange allows investors to defer federal income tax on the ‘sale’ of their property, the IRS will want to be able to track the properties you’ve exchanged.
By filing Form 8824 when a 1031 exchange has occurred, the IRS will be able to know if you’ve sold a property outright and should owe federal income tax on the prior exchanges that allowed you to defer the federal income tax.
We recommend an investor that is considering a 1031 exchange contact a tax professional or 1031 expert to walk them through any potential tax consequences of the exchange. There certain strategies that may be utilized to reduce the potential for taxable boot so that the entire exchange qualifies for tax deferral under Section 1031 of the Internal Revenue Code.