Real estate prices are being driven up by the purchase of second homes, which account for as much as 40 percent of the market.

"There's so much equity that's been built up throughout the last five years or more. People don't want to pay capital gains taxes which can be as high as 30 percent of the gain," says attorney David Greenberger who is president of 1031 Exchange Advantage, Inc.

He says investors can pay no sales tax on their investments regardless of whether or not they lived in them previously by using IRS Sections 121 and 1031.

Many people are familiar with IRS Section 121 -- the homeowners' exclusion. This law applies to your principal residence and allows a gain exclusion of $250,000 for single people and $500,000 for married people filing jointly. The gain exclusion funds do not have to be reinvested. There are requirements, such as the property must have been your residence for at least two years out of the past five-year period.

"[The 1031 exchange] can even be used on a personal residence that's converted into an exchange property, and the way you do it is you move out of your residence and a year later it can be an exchange property," he says.

A 1031 exchange is basically an unlimited tax break -- as long as you roll the money from the investment, non-owner-occupied property into another real estate purchase within six months, you will not incur property sales tax.

Combining Sections 121 and 1031 can create an even greater tax shelter for your real estate transaction. If a couple lives in a multi-family unit building, Section 1031 can be used to exchange the portion of the property that they do not live in and no taxes on the transaction are incurred when they purchase another real estate investment property. Section 121 can be applied to the unit the couple lives in.

"In this way, the unit they reside in is sheltered up to $500,000 in gain, and the remainder of the building is valued and exchanged as investment property under section 1031," Greenberger says.

Dividing the value between your residence and your investment property can be determined by the calculation of square footage or an appraisal of the unit that you are living in.

"You don't ever have to pay capital gains taxes if you plan it, but what is required is that your next move always be a trade into something else …," he says.

Using the 1031 exchange, you can buy an investment property and, after just one year you can live in it. Greenberger also says that you can sell one investment property and exchange it for more than one property.

He says, "The clear victory comes when the taxpayer who resides in a mixed-use property takes advantage of Sections 121 and 1031 to remove all taxes on gains and diversify into other properties." Greenberger adds "Clearly, living in a property that appreciates and does not present you with a tax bill when you leave makes for a very welcomed stay."

For more information on 1031 exchanges visit 1031exchangeadvantage.com.

Published: April 10, 2006

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Phoebe is a writer, speaker, and author. She is the Director of Business Development for Quality Service Certification and a trainer in customer service for the real estate industry. She is a Realtor with The Guiltinan Group, a division of Prudential California Realty. Her articles, feature stories, and columns appear in various publications including The Coast News, Del Mar Village Voice, and Rancho Santa Fe Review in San Diego. Phoebe worked for KGTV/10News in San Diego as a Newscaster, Reporter and Community Affairs Specialist for more than a decade. Phoebe's writing is also featured in Donald Trump's book: The Best Real Estate Advice I Ever Received. She is the author of If the Trash Stinks, TAKE IT OUT!: 14 Worriless Principles for Your Success. Contact Phoebe at 858.259.3646 or . Visit PhoebeChongchua.com for more information.