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When you are doing a 1031 Exchange, you generally want to hit three benchmarks called the napkin test. These are generalities that typically bear out to be good indicators of whether or not all of the gains will be deferred in a 1031 Exchange. Here are the benchmarks.
Step One – Equal or Greater Value
One, you typically want to buy a replacement property of equal or greater value than the relinquished property that you gave up. So, we want to go up in value, and get a bigger, better property.
 Step Two – Equal or Greater Equity
Secondly, we want to take all of our net equity, all of our proceeds from the disposition, the sale of our relinquished property. Imagine a big stack of poker chips in front of your relinquished property. I want to slide all of those poker chips over into the replacement property. So, I am moving all of my equity from A to B. So, the second rule of thumb is I want to move all of my equity into the replacement property rather than taking any cash or chips off the table, which would be treated as taxable boot.
Step Three – Off-set Your Debt Relief
The last benchmark, the third thing that I am trying to juggle, is that to the extent that I am paying off mortgages and debt on the relinquished property, I need to offset that debt relief with either new debt taken out in conjunction with the replacement property. So, I could take out a new purchase money mortgage, or I could assume the seller’s existing mortgage that would satisfy my debt relief if I acquired a replacement property with at least an equivalent amount of debt. Or, alternatively, I can offset my debt relief by putting more of my own cash into the replacement property. Cash in will also offset debt relief.
Coming Up Short on “Sufficient Valueâ€
 Well, here is where things get a little bit crazy. What if a person wants to acquire a replacement property that is not of sufficient value, but they are willing to gross up that price, fabricate, inflate the value of the price and report the transaction as if they acquired a replacement property of greater value. Let’s say that the real value of the property is $100,000, but the taxpayer grosses up the sale price to $150,000, so that they acquiring a replacement property of sufficient value. Suppose that they are buying from a friend who is willing to go along with it. Perhaps the friend is even willing to split the difference and to send back some of that inflated proceeds to the purchaser. They will give it back under the table. This is not acceptable. Filing a false or fraudulent tax return is a criminal offense. Knowing and willful attempts to evade or defeat income tax due is a crime.
There is a big difference between legally deferring your taxes in a proper 1031 Exchange and stretching the truth to fabricating the value of your replacement property.
Do Not Do the Crime
Section 7201 says that any person who willfully attempts to evade or defeat any tax imposed by this title, or the payment thereof, shall in addition to other penalties provided by law, be guilty of a felony. And, upon conviction thereof, shall be imprisoned not more than five years. Or they may be fined not more than $250,000 for individuals or both together with the costs of prosecution.
