Capital gains taxation on owner-occupied housing needs reform

Our current system of taxing gains on owner-occupied housing discourages long-term ownership of a family home, and it encourages frequent moves, which destabilizes families and neighborhoods.

taxmanWhen investors sell an asset for a profit, most of the time they pay capital gains taxes. Outside of a retirement account, there is only one exception: the waiver of capital gains taxes on the sale of a primary residence within certain parameters.

If an investor purchases a house and sells it within two years of the date of purchase, the transaction is considered a “flip” and the investor pays taxes on the gains as ordinary income. IMO, this is a good tax because the professionals who work in rehabilitation are businessmen, and flipping is how they generate income. Further, taxing flips discourages many novices from bidding up prices in the resale market to the detriment of owner-occupants.

However, if an owner holds the property for more than two years and lives in it for two of the last five years, the owner ignores the gains on the first $250,000 or $500,000 if it’s a married couple. If the owners(s) don’t make more than $250,000 or $500,000 on the sale — which most people don’t — then they don’t pay any capital gains taxes. It is a tremendous tax advantage that favors capital gains and appreciation.

While this flat exemption amount is easy to calculate, it also creates problems. The reason we have a large deduction or excluded amount is because years ago when there was no exclusion, long-term homeowners would be punished with capital gains taxes when they sold a principal residence when most of that gain was due to inflation. For the most part, this high exclusionary amount solves the problem, but not entirely. What is a person or couple supposed to do when their house increases in value more than the exemption?

Once house prices appreciate too much, the owner now has a strong disincentive to sell. And since this happens almost exclusively to long-term residents who are probably empty-nesters who no longer need the big house, this tax traps seniors in houses that no longer suit them, keeping a young family with children from occupying a house more suited to their needs.

This disincentive to sell is why this tax needs reformation.

Capital Gains Tax Hurts the Housing Market

I know many empty nesters who would like to downsize but don’t want to take such a big capital gains hit.

May 17, 2016reluctant-seller

“The Land of Facelifts” (Mansion, May 6) points to Proposition 13 in California as one of the main reasons homeowners are staying put rather than moving, thereby further suppressing the inventory of home listings and helping to keep home prices high. There is another reason the inventory of homes is so low. In California, those of us who purchased our homes more than 15 years ago are sitting on huge unrealized gains. I know many empty nesters who would like to downsize but don’t want to take such a big capital gains hit. Even with the $250,000 (for single filers) and $500,000 (for joint filers) exclusion from capital gains from the sale of a principal residence, the capital-gains taxes make selling and moving prohibitive to many people. If an empty nester sells, utilizes the exclusion and then pays capital gains taxes and our high California income taxes, there isn’t much inventory available to buy with the reduced net proceeds. We know many people in this situation, and they feel locked in.

Orene Kearn

Hillsborough, Calif.

What is the solution to this problem?

Personally, I favor the idea of linking the property basis to inflation. An exclusion can be created by linking the basis for the capital gains to the Consumer Price Index, and the tax can be levied on any overage. For instance. If someone purchased a home for $100,000 when the CPI was at 100, then later the property was sold for $300,000 when the CPI was at 200, the tax would be levied on only half the profit:

Adjusted Basis = Original Price times new CPI divided by old CPI

Adjusted Basis = $100,000 * 200 / 100 = $200,000.home_price_appreciation_fairy

$300,000 Resale Price

$200,000 Adjusted Basis

$100,000 Profit subject to Capital gains tax.

This solution would not punish long-term homeowners because their basis would continue to rise as long as inflation raised the CPI. These owners would be taxed if their neighborhood experienced a dramatic windfall, but then they were enriched by a windfall of home price appreciation, so it’s hard to be too upset about them paying taxes on the excess.

Unfortunately, it will likely never happen.

The big tax break for capital gains is what makes life as a mid-term flipper possible. There were many people during the bubble who bought with intention of flipping in two to ten years when their gains would not be taxed. While realtors may like the idea of everyone trading houses ever few years, this does nothing to create stable neighborhoods.

Favorable capital gains tax treatment is really a tax-free retirement savings account Uncle Sam worked into the system to benefit homeowners. If someone owns a property long enough to have capital gains, and the sale of that home represents a significant portion of family savings (which is usually does), the capital gains tax benefit can have significant financial impact on their financial life in retirement.


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