There are three ways to hold or transact real estate in a way that tax can be deferred. Sometimes you can even defer that tax forever!

1. Installment Sale: If you sell a property over time, that is called an installment sale. In other words, you will receive installments of payments over time. Each payment you receive is composed of at least two parts: (1) principal and (2) interest. The interest received will always be taxable just like any other portfolio income. However, in the case of the principal, it will actually be only partially taxable, depending on how it is apportioned between gain and return of capital.

The calculation is important for two reasons. First, you are required to report the mortgage interest that you receive on a Form 1098 on an annual basis to the person paying you. Second, you will need that calculation to complete your year-end tax return. In both cases, I strongly recommend that you use a qualified accountant to prepare and calculate the forms, or at least use them to check your math!

A word of warning regarding installment sales. If the IRS considers you a real estate dealer (involved in the trade or business of real estate trading), you cannot qualify for installment sale treatment on payments. If you are a dealer, you must take all of the gain as taxable immediately. That means you could be in the position of paying tax on income you have not yet received!

2. Buy real estate through your pension plan. Some pension plans allow the purchase of real estate through your pension plan. There are some rules to follow about how you do it and some restrictions as to how the mortgages are handled, but there a lot of benefits to doing your investing this way for example, with a regular pension plan, the gain is deferred until you withdraw it from your pension plan. With a ROTH plan, you ever pay tax.

3. Section 1031 – Like-Kind Exchange. Currently, under U.S. tax law you can exchange real estate with someone else, in certain circumstances, and defer the gain that you would otherwise have to declare. The most common way to do this is through a “like kind”, “Starker”, or Section 1031 Exchange. These are all different ways of saying the same thing.

The like-kind exchange is described in IRC Section 1031 and further defined in a court ruling, Starker v. Commissioner; hence the other names. To keep things simple, we refer to the exchange as a “like-kind exchange”. This is a specific exchange of real estate that has been owned for business or investment purposes. You cannot do a like-kind exchange (under this Code Section) on your personal residence or on non-real estate items. The like-kind exchange allows you to sell a piece of property that has appreciated, and “roll over” the gain into another piece of property. The second piece of property merely has to be another piece of business or investment real estate. It does not need to be the same type of investment property/ you can exchange many properties into one property or vice versa. For example, you could exchange a single-family residence into an apartment building or a single-family residence into many single-family residences or bare land into two single-family residences. The possibilities are almost endless.

There are some rules for like-kind exchange that must be closely followed. If you are considering a like-kind exchange, make sure you notify the real estate agent who is selling your property, as well as the title company. They will put you in touch with an exchange agent who will facilitate the sale and make sure the complex rules are followed.