This week in our series on tax breaks for real estate owners, we'll examine the so-called "tax-free" exchange and see why it is becoming so popular. In a nutshell, an exchange allows the investor to sell one property, replace it with another and pay no taxes on the transaction. This can be extremely helpful in moving your investments physically and in replacing one type of investment with another.

Here are the details:

• 1. Section 1031 of the IRS code says that only investment property or property held for trade or business can qualify for a tax-deferred exchange. Generally speaking, investment property is any real estate you purchase as a long-term hold. In contrast, if you buy a house for the purpose of fixing it up and selling it for a profit, the IRS calls that "inventory" and it would not qualify for an exchange. But if you rented that house out for a year or two, the IRS will likely view your house as an investment, and an exchange would be allowed.

• 2. As an investor owns a rental property for a number of years, it builds a potential tax liability in two areas: appreciation and depreciation. The increase in value is the appreciation, and it is typically taxed at 15 percent federal plus 6 percent in Georgia. In addition, any allowable depreciation deductions accruing over the years of ownership must be "recaptured" — in other words, the entire dollar amount of allowable depreciation over the years is taxed at 25 percent. These two levels of tax can add up fast, and the tax bill can sometimes exceed the amount of proceeds available to the seller. An exchange can help avoid some or all of that tax liability for a time.

• 3. A properly planned exchange allows the investor to sell his "old" investment for the best price he can get, then purchase one or more "replacement" properties and pay no tax on the transaction. The property must be "like-kind," meaning that all the replacement property must be held for investment, not used personally. So you might exchange a rental house for three smaller rental houses, or you could exchange an apartment building for a gas station and 10 acres of land. You can also use an exchange to physically relocate your investments if you are physically relocating yourself.

• 4. In order for an exchange to be totally tax-deferred, the seller must "spend the cash and replace the debt." In other words, if cash is received on the sale of your old properties, you must spend it all (or more) on your replacement properties. In addition, if you were relieved of any debt when you sold, you must make sure the replacement properties have an equal or greater level of debt on them when you purchase.

• 5. In addition to the monetary rules, there are rigid time frames imposed by the tax code. From the day you sell your old property, you have exactly 45 days to identify your replacement property or properties. There are specific rules governing this identification procedure. Furthermore, from the day you sell your old property, you have up to 180 days to purchase the replacement. Failing either of these "bright line" tests will cause your exchange to be disallowed.

• 6. Because of the complexity of this type of transaction, it should be planned carefully by the investor with the help of a qualified intermediary who specializes in exchange transactions. The intermediary cannot be anyone who has provided you professional services in the past, so your attorney and your accountant are immediately disqualified. Instead, there are firms that do nothing else but provide these services, and they are relatively inexpensive. For example, one critical rule is that the seller must not receive or have access to the proceeds of sale from the old property. On your behalf, the intermediary receives and holds these proceeds, and uses the money to pay for the purchase of your replacement property.

If you've gotten this far, you are likely beginning to feel the burden of the IRS rules on this procedure. That's because the IRS would prefer that investors simply pay the taxes on each transaction as they occur, rather than use this procedure to postpone the day of tax reckoning.

But the great advantage for investors is this: By performing an exchange, the investor can keep his money at work and postpone paying tens of thousands of dollars in tax.

For a more in-depth discussion of exchanges, visit my Web site.

Find more articles by John Adams online at ajchomefinder.com.