Capital Gains Taxes on Principal Residences are Freezing the Housing Market
Time for a tax change incentivizing home sales by people with substantial gains on their home.
Highlights:
· Many homeowners are locked into their principal residence due to a high capital gain bill should they sell their home.
· A well designed tax incentive would encourage people with substantial house equity to sell their principal residence and realize a capital gain.
· A reduction in the capital gains tax rate on proceeds used from the sale of a principal residence for the purchase of a new principal residence could actually increase tax revenue to federal and state governments.
· An increase in the current capital gains tax rate applied to all assets could reduce the number of homeowners with substantial house equity choosing to sell their current residences.
Introduction: Many homeowners, despite a desire to downsize, have decided to stay put in their current home because of the capital gains tax incurred from the house sale. This paper describes how existing tax rules on capital gains from a home discourage some people from selling their home and how an alternative tax rule could encourage more older households to sell their home.
A tax incentive which encourages home sales by people with with substantial equity could increase economic growth. The sale of a large home with substantial equity could initiate several additional transactions including, the purchase of a retirement home by the seller, the sale of a first home by the buyer of the large home, and the purchase of a first home by a renter. The National Associate of Realtors estimates that the median house sale can create $113,000 in economic activity.
Capital gains taxes on the sale of principal residences: The gain on the sale of a principal residence is taxed as a capital gain. IRS rules allow for the exclusion of $250,000 for people filing separate returns and $500,000 for people filing married joint returns.
Many long term homeowners have substantial equity and would be subject to a large capital gains tax if they sold their existing home. The current capital gains tax rates are 0%, 15% or 20% depending on the income of the taxpayer. In addition, the gain on the home may be subject to the net investment income tax, of 3.8% depending on the income of the taxpayer.
The sale of a home with a large gain will trigger both the largest capital gains tax rate, 20 percent, and the 3.8 percent net investment income tax (NIIT). A person who purchased a home 15 or 20 years ago for around $800,000 might have a gain of $1,500,000. A household with filing status single would pay tax on all gains over $250,000 and be subject to a 20 percent capital gains tax rate and the 3.8 percent NIIT.
· The tax owed on this transaction would be $297,500 (0.238 * $1,250,000).
By contrast, a person who immediately sells an inherited home will pay very little in tax because the cost basis of the inherited home is the fair market value of the property at the time of death of the original owner. Older homeowners with substantial income or retirement wealth, have a strong incentive to maintain home ownership and die in their existing dwelling.
Proposed Tax Changes: A tax exemption or a tax decrease on a portion of the capital gain used for the purchase of a new principal residence or for long-term care expenses would increase the tendency for people with substantial house equity to sell their home and relocate. The increased propensity from this tax incentive could be especially pronounced among older households who are considering whether or not to downsize and older owners who are attempting to maximize the value of their estate left to heirs. (For more about how the capital gains tax rate will impact the decision of an older homeowner to downsize or stay put go to the memo – The House Downsizing Decision Tree.
There are two ways to structure this tax change.
The first method, a tax exemption, would be analogous to the 1031 exchanges on investment properties. A 1031 exchange allows taxpayers to defer capital gains taxes on the sale of a business or investment property that is invested in a new property. The portion of the proceeds not invested in a new property would be subject to tax.
A tax incentive for the sale of principal homes based on a 1031 exchange for principal homes could lead to a large loss of tax revenue because there is no limit on the number of times a person could conduct a 1031 exchange.
The second method involves a reduction in the tax rate on all proceeds from a sale of the principal residence used to fund a purchase of a new principal residence or for funds used to pay for the expense of a nursing home at the end of life.
Consider the implementation of a 5.0 percent tax rate on funds used to purchase a new $1,000,000 principal residence when the total gain is $1,500,000. In this instance, $250,000 remains untaxed for a single filer, $1,000,000 is subject to a 5.0 percent capital gains tax and a 3.8 percent NIIT, and $250,000 is subject to a 20 percent capital gains tax rate and a 3.8 percent NIIT.
· Total tax is $147,500 (0.088*$1,000,000 +0.238*$250,000), substantially lower than the tax bill of $297,500 under current law.
This capital gains tax is never paid of the homeowner who dies in the house because the person inheriting the house can claim the fair market value of the home at the time the original homeowner dies as the basis for the capital gain.
A tax break that encourages people to sell their home can encourage the receipt of capital gains realizations and increase tax revenue.
Preferential Tax Treatment of gains used for long term care expenses:
Current law requires people who want to claim the Medicaid long term care benefit to spend down all assets. A provision providing a lower tax rate on funds used from the sale of home for long term care expenses would reduce reliance of Medicaid long term care services, potentially saving money for taxpayers and allowing households to obtain better care than what could be obtained under the Medicaid long term care program.
Concluding Remarks: The observation that capital gains taxes can reduce the tendency for taxpayers to realize capital gains is not new. The topic was robustly studied by Treasury economists in the 1980s when Congress was debating the effects of lower capital gains tax rates. The conclusion reached by several studies is that a reduction in the capital gains tax rate can cause some taxpayers to increase the amount of asset sales, thereby offsetting the impact of lower rates on revenues.
Most of the previous empirical work involves the analysis of panel and cross sectional tax files. Most gains involved the sale of equity, not real estate. Revenue effects were highly influenced by gains from high net worth individuals because of the high concentration of stock market wealth.
Housing wealth is more widely dispersed than stock market wealth. However, tax rates and incentives, like the ones described here, will also impact the realization of gains on housing. Additional empirical work is needed to evaluate the tax incentives described in this memo and the impact of increases in capital gains tax rates on the sale of homes owned by people with substantial house equity.