1031 Exchange Requirements

"The Napkin Test"

(Listen Here 5:45 min)

The complex tax regulations involved in 1031 exchange accounting have been simplified into 3 general rules of thumb called, "The Napkin Test."

In order to totally defer all of the gain, you must:

• RULE 1: Trade Up or Equal in VALUE from the relinquished property to the replacement property. (i.e. you purchase a replacement property of equivalent or greater cost)

• RULE 2: Trade Up or Equal in EQUITY from the relinquished property to the replacement property.  (i.e. you re-invest all of your net proceeds or equity that results from the sale of your relinquished property into your replacement property)

Note For Accountants: If you trade down in value and/or equity, then you will recognizes gain to the extent of the decrease in value or equity, whichever is greater, reduced by standard transactional expenses.

• RULE 3: You need to OFF-SET ANY DEBT RELIEF on your relinquished property with either: (i) new debt on your replacement property; or (ii) by investing more of your cash in the purchase of your replacement property.

Note For Accountants: Your basis in your replacement property will be the value of your replacement property less the amount of gain you deferred from the relinquished property.  {NEW BASIS = (FMV-GAIN DEFERRED)}

Here is the very technical explanation:

Value Analysis: You must account for any difference in value of your relinquished property in relation to your replacement property.  Exchanging up in value adds to your basis in your replacement property. While Exchanging down (net of standard transactional expenses) means that the you have received taxable boot.

A trade down in value or equity is caused by either:

(i) you have received "boot" in the form of cash (or other non-like kind property) instead of reinvesting your proceeds into your replacement property (trade down in equity);

or

(ii) you received a replacement property of lesser value than your relinquished property by reinvesting all of your proceeds, but incurring less debt on the replacement property than the amount of debt that was discharged in conjunction with the sale of your relinquished property (trade down in value).  If you trade down in either value or equity (net of exchange expenses), then you must recognize gain to the extent of the decrease (up to the amount of your entire realized gain).

Equity Analysis: Next, you must move all of the equity from your relinquished property into the replacement property.  Your Equity is essentially your sales price of the relinquished property less the amount of mortgages, debts or liabilities you had to pay off in order to convey clear title to your buyer.  {EQUITY = (SALES PRICE - MORTGAGE)}

Mathematically your equity has to go somewhere. Your equity will either be:

(i) reinvested in replacement property or used to pay standard exchange expenses (this would be NOT be taxable to you);

or

(ii) received by you as taxable boot, including the use of equity to pay non-standard closing costs that are not exchange expenses (this would be taxable to you).

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