The biggest investment for most people is the house they live in. The next biggest investment is often an employer-sponsored savings plan. But investing in non-owner-occupied real estate can be far easier, more lucrative and a safer bet than many people realize. It also can be a great tax-avoidance scheme, fully-approved by the Internal Revenue Service.

IRS rules allow sellers of many kinds of real estate to defer capital gains taxes and, sometimes, to avoid them altogether. Deferring capital gains tax means that a taxpayer can make more and more profits from real estate, but indefinitely delay payment of tax on the profits until he or she is best able to afford paying. Taxes can even be deferred for the full life of the taxpayer, with payment coming out of the taxpayer's estate.

When most people think of real estate investing, they think of office buildings and apartment complexes. They think of subdivision developers and resort owners. While these are common aspects of real estate investing, the reality is that many kinds of much smaller properties can provide proportionally similar returns and easier management to investors with much smaller budgets. And the tax benefits are the same to small investors as they are to large investors.

Two aspects of IRS rules provide the primary guidance for payment of taxes on profit from real estate. The first relates to the sale of a primary residence that may have also been used as a rental, and the second relates to property held solely for investment purposes.

In the first case, the Internal Revenue Code (the law governing payment of taxes to the federal government) allows property owners to avoid capital gains taxes on the sale of a home if the owner used the home as his primary residence for two out of the five years preceding the sale date. This exclusion applies to the first $250,000 of gain for a single filer and $500,000 of gain for a married taxpayer filing jointly. This law applies to the sale of a conventional single-family home, as well as to the sale of a houseboat, condominium, cooperative apartment or mobile home.

This provides a home buyer an avenue to purchase his residence for little or no money down, live in it for two years, then borrow against the equity to purchase a better home to live in while renting out the original home for the next three years. The buyer uses rent payments from the original home to pay the original mortgage and ownership expenses, then completes the sale of this home by the end of the fifth year, completely pocketing all the profit from market appreciation during the time of ownership (up to the IRS limits).

A home buyer can keep doing this, time after time, as long as the income from his regular occupation is sufficient and stable enough to permit him to transition from one home to the next, and as long as market conditions permit. Occasional variations in the real estate market and differences in an individual's financial circumstances may not make this practical for all investors.

The second provision of the Internal Revenue Code deals with what the IRS and investors often call a "1031 exchange." But don't let the word "exchange" fool you. These are not exchanges in the traditional sense.

Most people think of an exchange as a trade. One party giving an item to second party in exchange for something the first party wants from the second party, a sort of bartering. This is not how a 1031 exchange works, yet the IRS still treats it as if it were a simple trade between two parties, allowing real estate sellers to avoid paying taxes they might otherwise have owed on any gain.

IRS rules spell out specific steps that must be followed to qualify the sale of a property as a 1031 exchange. While the steps are relatively simple, failure to follow them precisely can result in the IRS not counting the sale as an exchange, which can result in a hefty tax bill.

More information about IRS Section 1031 tax-deferred exchanges will be added to this page in future weeks.