The “Napkin Test” for Quickly Evaluating 1031 Exchange Feasibility
A Simple Rule to Avoid Boot and Maximize Tax Deferral
Before diving into a 1031 exchange, investors often want a quick way to determine whether their numbers will work — without complicated spreadsheets or tax software. That’s where the “Napkin Test” comes in.Used widely by Qualified Intermediaries and real estate professionals, the Napkin Test is a simple way to see whether your exchange will fully defer capital gains taxes or whether you might accidentally create boot, which becomes taxable.
Here’s how it works.
What the Napkin Test Measures
A 1031 exchange aims to defer taxes by reinvesting all proceeds into a replacement property.To fully defer taxes, you generally must:
Reinvest all net equity
AND
Replace equal or greater debt than you had on the relinquished property.
If either of these two conditions isn’t met, you may trigger boot — which reduces your tax deferral.
The Napkin Test Formula
To avoid taxable boot:
Buy equal or greater value than the property you sold.
Roll over all equity from the sale into the new property.
Match or increase your loan amount (or bring cash to closing to offset debt reduction).
If all three conditions are met, your exchange typically passes the Napkin Test.
Example:
You sell a property for $1,000,000 with:
$400,000 in equity$
600,000 in debt
To fully defer taxes, your replacement property should:
Cost at least $1,000,000
Use all $400,000 of your equity
Include $600,000 or more in financing (or equivalent cash contribution)
If you reinvest less equity — or take on less debt without replacing it — the IRS considers the difference taxable boot.
Why the Napkin Test Matters
It’s a quick reality check that helps investors:
Avoid surprise tax bills
Understand whether boot is likely
Adjust financing before closing
Plan strategically for partial exchanges
While the Napkin Test doesn’t replace professional tax advice, it’s an essential first step in evaluating feasibility.
The Napkin Test gives you a fast, simple way to determine whether your exchange is on track for full tax deferral. If you can match or exceed value, equity, and debt — you’re likely in good shape.
Thinking about a 1031 exchange? We can help you run the numbers and structure your exchange for maximum tax savings.
