Many real estate fortunes have been earned by savvy investors who understand how to avoid capital gains tax when selling their investment properties. The best-known example was documented in the classic best-seller real estate book, "How I Turned $1,000 into $5 Million in My Spare Time," by the late William Nickerson, who pyramided his way to wealth without tax erosion of his profits.

THE TAX SECRET IS MAKING TAX-DEFERRED EXCHANGES. If you want to learn how to build your real estate investment wealth without owing capital gains tax as you do so, like Nickerson did, the secret is tax-deferred exchanges, as authorized by Internal Revenue Code 1031.

The simple tax rule for avoiding capital gain tax when disposing of a rental or investment property is that the investor must trade "equal or up" in both price and equity for one or more qualifying "like-kind" properties without removing any taxable "boot," such as cash or net mortgage relief.

I shall never forget my first tax-deferred exchange years ago. I owned a three-unit apartment triplex in which I had a modest capital gain. After reading Nickerson's great book, I had dreams of pyramiding my way to a real estate fortune.

My first step was to make a tax-deferred trade of my three units for a nine-unit "fixer-upper" apartment building worth about three times as much as my old property. But the sellers of that building wanted to retire; they didn't want my triplex.

So my savvy real estate agent found a "stand-by buyer" for my three units after I made my tax-deferred exchange for the nine apartments. I got my tax-deferred exchange, the seller of the nine apartments got a taxable cash sale, the stand-by buyer acquired my three units, and we all lived happily ever after.

TODAY'S TAX-DEFERRED "STARKER EXCHANGES" ARE MUCH EASIER. After 1984, when so-called Starker exchanges became legal in Internal Revenue Code 1031(a)(3), investment property trades became even easier.

Investors no longer have to make direct trades, as I did in that exchange of three units for nine units.

Today, I could sell my triplex, have the sales proceeds held by a third-party accommodator or intermediary beyond by "constructive receipt," and then use that money to buy the nine apartments.

However, there are strict Starker-exchange time limits. After the first property in a Starker trade is sold, and the sales proceeds are held by a qualified third party, the "up trader" has 45 days to designate to his accommodator or intermediary the property to be acquired. For this reason, it is wise to have the "up leg" of the exchange lined up before selling the old property.

Up to three possible property acquisitions can be designated. Then the trader can take up to 180 days from the sale date to complete the tax-deferred acquisition.

More than one property can be traded on either side of the exchange. For example, I could trade two rental houses for one apartment building of equal or greater cost and equity. Or I can trade my office building for three rental houses of equal or greater total cost and equity.

WHAT IS A "LIKE-KIND" EXCHANGE? As mentioned earlier, Internal Revenue Code 1031 requires a "like-kind" property trade. But "like-kind" does not mean "same kind."

"Like-kind" simply means all properties in the tax-deferred exchange must be held for investment or for use in a trade or business. Virtually the only properties that are not eligible for tax-deferred trades are (1) your personal residence, and (2) property owned by a "real estate dealer" such as a home builder.

For example, if you own a rental house you want to exchange for an office building of equal or greater cost and equity, that situation qualifies. Or you can trade your vacant land, held for investment, for a shopping center, warehouse, or rental house.

WHY EXCHANGE INSTEAD OF SELLING REAL ESTATE? The obvious reason for trading investment or business property, instead of selling it, is to avoid the capital gains tax on the profit. But there are at least 10 other reasons to exchange.

They include (1) pyramid your investment property equity without tax erosion of your sale profit, (2) minimize or eliminate the need for new mortgage financing on the property acquired, (3) acquire more desirable property to replace an undesirable property, (4) increase your depreciable basis, (5) acquire a property that better meets your investment or business needs, (6) partially defer your profit tax while trading down to a smaller property that is easier to manage, (7) avoid the dreaded 25 percent depreciation recapture tax when selling an investment or business property,(8) refinance either property before or after (but not during) the exchange to take out tax-free cash,(9) accept an unexpected desirable purchase offer to sell a currently-owned property and avoid capital gain tax, and (10) completely avoid capital gains tax by still owning the last property in your pyramid chain of tax-deferred trades when you die.

HOW TO MAKE A TAX-DEFERRED TRADE FOR YOUR ULTIMATE DREAM HOME. Savvy real estate investors, especially those desiring to retire, tried to figure out how to make tax-deferred exchanges of their investment or business properties for their ultimate dream homes. However, as explained earlier, personal residences don't qualify for IRC 1031 tax-deferred trades because they are "unlike property."

The simple solution is to make a tax-deferred exchange up for your ultimate dream home. However, because a personal residence can't qualify, the acquired property must be a rental at the time of the trade. Most tax advisers suggest renting it to tenants for at least 12 months before converting it to the investor's personal residence.

In 2004, Congress plugged a big loophole in this scheme where an investor could move into a dream home acquired in a trade by living in it for at least 24 months before selling it and claiming the generous Internal Revenue Code 121 principal residence sale tax exemption up to $250,000 for a single owner or up to $500,000 for a qualified married couple filing a joint tax return.

After Oct. 22, 2004, for sales of a principal residence acquired in an IRC 1031 tax-deferred exchange, the home must be owned at least 60 months before sale (rather than the minimum 24 months of ownership ordinarily required). At least 24 of those 60 months must be owner-occupied to qualify for the IRC 121 exemptions.

THE ULTIMATE TAX SHELTER OF ALL. However, if you acquired your ultimate dream home, and perhaps millions of dollars of investment property, in tax-deferred exchanges, which you still own at the moment of your death, you will have achieved the ultimate tax shelter of all.

Uncle Sam will be so overcome with grief at your passing, he will completely forgive any capital gain tax or depreciation recapture tax that would have become due if you sold your real estate the day before your death.

However, the net worth of your real estate (market value minus secured debt) will be included in your estate. For deaths after Jan. 1, 2006, total estate net assets less than $2 million are fully exempt from federal estate tax. Also, assets left to a surviving spouse are free of the federal estate tax.

To make matters even better, your heirs will be overjoyed to learn they will receive a new "stepped-up basis" to market value on the date of your death for the assets they inherit. For complete details, please consult your personal tax adviser.

Next week: How to maximize home office tax savings.