Section 1031 of the Internal Revenue Code allows you to roll the gain from the sale of your Old investment property over to your New investment property. There are a number of rules you must follow for your exchange to be valid, but perhaps the most confusing are the reinvestment rules.

Simply put, the reinvestment rules state that in order to pay zero tax on your exchange, you must do two things: you must buy equal or up; and you must reinvest all the cash. Let's take the first part: you must buy equal or up. To not pay any tax on your exchange, your New Property must be equal to, or greater than, the sales price of your Old Property. (While the law actually allows you to adjust your calculations for closing costs on the Old and New Properties, this article will be easier to understand if we put that fact aside for now).

To illustrate the equal-or-up rule, let's say that Fred and Sue sell their rental duplex for $100,000. In order to pay zero tax on their 1031 exchange, they must buy their New Property for at least $100,000. What happens if, instead of buying a New Property for $100,000, they only pay $90,000 for it. Is their exchange toast? No. Their exchange is not toast, but they will pay tax on the $10,000 buy-down. And the whole $10,000 of buy-down is taxable because, in an exchange, the gain comes first and you can not apply any of your cost against the $10,000. It's all taxable gain.

The second part of the rule is that, again, in order to pay zero tax, you have to reinvest all of the cash. To illustrate this, let's take our example from above and change it slightly -- instead of purchasing the New Property for $90,000, Fred and Sue are paying $150,000 for the New Property. When they sold their duplex for $100,000, they paid off debt of $40,000 and the balance of $60,000 was sent to their intermediary. Fred and Sue are getting a mortgage of $100,000 for this property, meaning they will only use $50,000 of the proceeds that their intermediary is holding.

They don't have an equal-or-up problem since they are buying up (they sold for $100,000 and are buying for $150,000). But since they are reinvesting only a portion of the proceeds that their intermediary is holding (the intermediary received $60,000 from the sale of the Old Property, but Fred and Sue are only reinvesting $50,000), the unspent proceeds of $10,000 are taxable. As in our discussion of buying equal or up, the entire $10,000 is taxable.

So, to restate the reinvestment rule again: in order to pay zero tax you have to buy equal or up, and you have to reinvest all of the cash. Notice that I did not say that you have to have debt on the New Property at least equal to the debt that was paid off on the Old Property. Many people, especially CPAs and attorneys, seem to think that this is a rule. But it's not -- you simply have to buy equal or up, and you have to reinvest all the cash.

Let's say that Fred and Sue are buying a New Property for $100,000 (the same price that they sold their Old Property for.) They paid off a mortgage of $40,000 on the Old Property, and their intermediary is holding the balance of $60,000. When they buy the New Property, after using the funds held by their intermediary, they are going to need an additional $40,000. These additional funds can come from their savings account, or a new loan, or some combination of the two -- say a $20,000 loan and $20,000 from their savings account; it doesn't matter.

So as long as you adhere to these reinvestment rules you can defer paying tax on any of the gain. By doing a 1031 exchange not only can you avoid paying both federal and state capital gains tax, but you can also defer the recapture of depreciation tax that you have taken on your old investment property. That amount can be significant since the rate of tax on recapture in 25 percent.