One of the biggest tax hits you'll likely ever take is when you sell investment real estate. Although taxes are a way of life, avoiding taxes is also as American as apple pie. Fortunately for all of us, there are ways to reduce (and even eliminate) taxes legally.

One of the most loved loopholes the rich use when selling real estate is Section 1031 of the Internal Revenue Code. Established in 1928, Section 1031 lets you escape 100% of the tax on the sale of a property by exchanging it for another. Knowing the basic 1031 rules as they apply to real estate can save you a fortune (and make you even more).

1031 Rules to Know

1. To be totally TAX FREE, the purchase price (VALUE) of the newly acquired "exchange" property must be equal to or greater than the sale price of your original property, and equal to or greater in debt.

2. All the proceeds from the sale of your first property must be used to purchase the "exchange" property.

3. The real estate must be of "like kind," meaning both properties must be investment properties. (They do not have to be of identical use. You can exchange a rental condo for a strip mall, or vacant land for an apartment building. However, real estate outside the U.S. is not of like kind.)

4. You cannot exchange personal residences. The property must be used for business, trade or investment.

5. You can sell one property and buy several properties. Or you can sell several properties and buy one.

6. This is not a self-administered transaction. The cash from the first sale must go through a "qualified intermediary" and not directly to you or an agent working for you or who has a fiduciary relationship with you. If you (or your agents) take the cash, you pay the tax.

7. You do not have to sell one property and buy the exchange property simultaneously. You have 45 days from the closing of the first sale to identify up to 3 potential exchange properties. You have 180 days from the closing of the first sale to complete the exchange sale(s).

8. You can exchange for a property that is under construction. But you cannot use its future completed value. The value of the unfinished property as it stands when you take title must be equal your gains from the first property.

9. A partnership can sell and exchange real estate as long as it takes title in the name of the partnership.

10. You cannot buy a property that is "held primarily for sale." Meaning if you intend to do a quick flip of the exchange property, it will not qualify.

These rules are just the tip of the Section 1031 iceberg. The more you know about Section 1031 the more questions you'll likely have. For example, although you now know the real estate exchange has to be of "like kind," that does not mean it has to be of like quality. You can exchange an improved property for one that needs major rehab.

You do not have to "trade" properties with the same individual. You can sell your property to one person and by your exchange property from another. It's not, "you give me your property and I'll give you mine."

More for Your Money

Paying no tax isn't the only advantage. Exchanging real estate gives you greater buying power. Instead of using after-tax dollars, you're using 100% of your money. If you made a $1 million profit on the sale of a property, as much as $300,000 that otherwise could have gone straight to that taxman can instead go toward the purchase of another property.

If you're ready to snowball your real estate portfolio into bigger and better properties, consider the 1031 exchange. It can get you there faster and tax-free. With proper estate planning, you (and your heirs) will never pay a dime of tax on the gains. And that's a very good thing.