There's an old saying that there are two things you cannot avoid in life: death and taxes. This may be so, but it's good to know you can do certain things to defer the inevitable. For one thing, you can eat your vegetables, exercise and hope for the best. When it comes to deferring taxes, you can take advantage of the Internal Revenue Code, Section 1031.

The concept of Section 1031 has been on the books since 1921, and is one of the last significant tax advantages remaining for real estate investors. The key advantage of a Section 1031 exchange is the ability to sell a property without paying any capital gain tax, or depreciation recapture at closing, which allows the earning power of the deferred taxes to work for the benefit of the investor instead of the government. It's essentially an interest-free loan from the government.

Basic Requirements
Although Section 1031 refers to "an exchange of property," it does not require a simultaneous "swap" of properties. In 1991, the IRS described how to convert a sale and subsequent purchase of property (or "delayed" exchange) into a tax deferred exchange by employing what the IRS calls a "qualified intermediary."

A qualified intermediary is an entity who enters into a written agreement with the taxpayer ("exchanger") to acquire the exchanger's rights and/or ownership interest in the property the exchanger is selling ("relinquished property"), and transfers such ownership interest into one or more properties of "like-kind" that the exchanger chooses to buy ("replacement property").

In other words, the intermediary is "assigned in" as the seller of the property during the closing process. It is this assignment that allows the seller to become an exchanger, and, essentially, convert an otherwise taxable sale and subsequent purchase of investment real estate into a tax-deferred exchange.

Because the intermediary is technically the seller who receives the sale proceeds, it prevents the exchanger from being in "actual or constructive receipt" of the proceeds; thus, there is nothing to tax.

There are three main requirements to be met before reaping the rewards of a tax deferred exchange:

'Like-Kind' Property
IRS code, Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment."

Thus, it is imperative that the relinquished property and the replacement property both be held for "productive use in a trade or business or for investment."

The term "like-kind" property has been given a broad interpretation by numerous IRS revenue rulings and private letter rulings, where authorities have validated exchanges between and amongst several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments--even leasehold interests exceeding 30 years.

For example, Tom Taxpayer owns a single family rental house in San Jose. He can exchange that property for an apartment building in Sacramento; Iris Investor owns five acres of land in Texas. She can exchange that property for a retail shopping center in Los Angeles.

Properties that are clearly not "like-kind" to real property held for investment are an investor's primary residence or personal property. Like-kind property also does not include stock in trade or property held primarily for sale, stocks, bonds, notes, certificates of trust, or interest in a partnership.

Identify Replacement Properties
The IRS requires an exchanger to identify, in writing, the replacement property(s) within 45 days from the transfer of the relinquished property. The rules for identification are as follows:

• Three property rule--An exchanger may identify up to three properties, without regard to the fair market value of those properties;

• 200 percent rule--An exchanger may alternately identify an unlimited number of replacement properties, if the total fair market value of all the properties is not more than twice the value of the relinquished property (200 percent of the relinquished property);

• 95 percent rule--If the exchanger wishes to list more than three possible replacement properties and cannot meet the "200 percent rule," the exchanger may do so only if he receives 95 percent of the value of all properties identified.

Since an exchanger must acquire property identified within the 45-day period to qualify for tax deferral, any properties identified should be properties the exchanger is seriously considering. The three property rule is the rule employed in the majority of cases, since most investors do not intend to acquire more than 3 properties.

Acquire Replacement Property
The exchanger must close on the replacement property by the earliest of either: 1.) 180 calendar days after the transfer of the relinquished property or 2.) the tax return due date for the year the relinquished property was transferred, unless a tax filing extension is obtained.

For example, if John, an individual investor, transferred his relinquished property on December 15, 2000, he is required to purchase and receive his replacement property by April 15, 2001, when his year 2000 taxes are due. This is because the exchange must be completed in the same tax year in which the relinquished property is transferred.

However, if John obtains an extension to file his taxes, he will have until the 180th day to purchase and receive his replacement property, which is June 13, 2001.

It is important to note that in order to defer all capital gain taxes, an exchanger must 1.) buy a property or properties of equal or greater value (net of allowed closing costs), and 2.) reinvest all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debt liabilities not made up for with additional cash from the exchanger, is considered "boot," or taxable income.