One way is to sell your principal residence. Under Section 121 of the Internal Revenue code, you can sell a house you have lived in for the last two years and exclude from taxation any profits up to a quarter million dollars per owner. Under the same section, married couples can exclude up to half a million dollars from tax, and that covers most home selling situations.

But there is another way to avoid the tax bill, and it is outlined under section 1031 of the IRS code. Often called a Starker swap or a "tax-free" exchange, this procedure is correctly titled a "tax deferred" exchange. And it applies only to investment properties.

We can loosely define "investment" property as any real estate you own as a "long term" investment and that you do not live in or own as a secondary residence. For example, if you have a cottage at the beach that you visit for more than two weeks a year, that is probably a secondary residence. But if that same cottage is rented out to others almost year round and you rarely use it, it is likely considered an investment by the IRS.

In a nutshell, section 1031 of the tax code says you can sell one investment property and replace it with any other investment property, and if you follow the rules, you won’t have to pay any tax on the transaction.

So, what are the rules?

1. You have to put a phrase in the contract for the property you are selling which notifies the buyer that you are selling this property as the first step in an exchange. In most cases, the seller has no reason to care, but you have stated your intention to the IRS.

2. Beginning with the day you close the first sale, you have exactly 45 days to identify in writing the property you intend to acquire as a replacement or "target" property. The identification must be made to a third party, and preferably to an IRS approved "intermediary," who is a specialist in these transactions.

3. Also, from the day you close on the first sale, you have exactly 180 days to close on the target property (or properties). You can sell one and exchange into multiple properties. And although the logistics get confusing, you can sell many properties and exchange into one (or more). But the time limits are strictly 45 days and 180 days with no exceptions.

4. All properties must be what the IRS considers "like-kind." That does not mean apartment building for apartment building. Instead, it means any investment property for any other investment property. So you might exchange raw land for a rental house, or you could exchange an apartment building for an office condo. You might even exchange several rental houses you own for a single, very nice rental house at the beach, provided you use the beach house strictly for investment and not personal usage.

5. This next rule is what makes the whole process tricky. In order for the exchange to be truly tax free, you have to spend the cash from the sale of the old property on the purchase of the replacement property. Any left over cash is called "boot," and you will be taxed on that amount as if it were profit from the sale. In addition, you must structure the purchase of the replacement property so that there is at least as much debt on the new property as there was on the one you sold. So the distilled version of this rule is this: "spend the cash and replace the debt."

6. One more caution: you can never touch the money. Any proceeds from the sale of the first property must be held by a third party intermediary during the entire transaction. If the IRS determines that you had "constructive receipt" of the money (meaning that you had actual control of the funds), they can disallow the entire transaction.

Having your transaction disallowed is not the end of the world. You won’t go to jail and you won’t have your credit report ruined. But a failed exchange will mean that the sale of the "disposed of" property will be taxed as a regular sale, and that means you will owe whatever taxes you would have owed if there were no exchange in the first place.

Typical taxes on the sale of an investment property would include a tax of 15% on long term capital gains (what it sold for less what you paid less what you put in it to improve it). In addition, the state of Georgia wants 6% of the same gain. And to make matters worse, the IRS wants to recapture any depreciation you have taken over the years at a rate of 25%. Depending on how long you have held the property, that may or may not be a significant amount.

In any case, many investors would prefer to spend the cash and replace the debt, and thereby avoid any tax whatsoever. Next week, we will look at some common pitfalls in an exchange transaction, and examine a recent IRS ruling regarding principal residences obtained as part of an exchange.