Debt service generally refers to the cash that is required to cover the repayment of interest and principal on a debt for a particular period.
In the context of the 1031 exchange industry, the concept of debt service is crucial. A 1031 exchange, as per the U.S. tax code, allows investors to defer capital gain taxes when they sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
However, if a taxpayer is replacing debt on the relinquished property with new debt on the replacement property, the debt service might change, depending on the interest rates and terms of the new loan.
Therefore, when analyzing potential replacement properties in a 1031 exchange, investors should consider not only the purchase price but also the potential debt service associated with any loans on the new property. This is to ensure the cash flow from the replacement property is enough to cover the debt service and other expenses.
It’s worth noting that there are specific rules regarding debt in a 1031 exchange. Generally, to fully defer all taxes, an investor must purchase a replacement property with a value equal to or greater than the relinquished property. This often includes replacing any debt that was paid off from the sale of the relinquished property. If the investor doesn’t replace the debt or doesn’t make up for it with additional cash, it could be considered a form of “boot” and may be subject to tax.