The "napkin test" in real estate exchange terms is a quick method to determine if an exchanger will have taxable boot in a 1031 exchange by analyzing the values, equities, and mortgages involved in the transaction. It helps determine if the exchanger is trading "up" or "across" in value, equity, and mortgage.
Here's a breakdown:
The exchanger's current property is labeled "A," and the property they intend to acquire is labeled "B." The napkin test assesses whether the exchanger is:
- Trading up or across in value.
- Trading up or across in equity.
- Trading up or across in mortgage debt.
If the exchanger is trading down in any of these categories, they may have taxable boot.
Example:
Let's say an exchanger is trading from property A to property B. Using the "napkin test," we find:
- Value: Property B is of higher value than Property A. (Trading Up)
- Equity: The exchanger's equity in Property B is equal to Property A. (Trading Across)
- Mortgage: The mortgage on Property B is higher than the mortgage on Property A. (Trading Up)
In this scenario, the exchanger is trading up in value, across in equity, and up in mortgage. Therefore, they would not have taxable boot.
If, however, the new mortgage on property B was lower than the mortgage on Property A, then the difference would be considered boot and potentially taxable.
Essentially, the "napkin test" offers a preliminary assessment of the tax implications of a 1031 exchange, making sure the exchanger is moving to a property of equal or greater value and debt. It is crucial to consult with a qualified tax advisor or exchange professional for accurate and personalized advice regarding 1031 exchanges and potential tax liabilities.
