In 1997, President Bill Clinton signed legislation that, 30 years later, would make it nearly impossible for young families in California to buy homes.
The Taxpayer Relief Act of 1997 created an exclusion from capital gains taxes on the sale of a principal residence. It meant that an eligible individual or a married couple selling a home that had gone up in value would not have to pay tax on the first $250,000 (for a single owner) or $500,000 (for a couple) of profit on that sale.
This provision, Section 121 of the Internal Revenue Code, replaced Section 1034, which had allowed homeowners to defer paying capital gains taxes on the sale of a primary residence by purchasing a new home of equal or greater value within two years. People could “rollover” their capital gains tax obligation instead of having to pay it when they sold their house.
How much have home prices gone up since 1997? Per Redfin, a 5-bedroom home in Northridge that sold for $237,500 in 1997 is valued today at $1.145 million.
The capital gains tax exclusion of $250,000 and $500,000 has not gone up at all. So a couple that purchased a home for $237,500 and sold it for $1.145 million would have a capital gain of up to $907,500. After a $500,000 exclusion, they’d owe capital gains tax on $407,500.
Depending on their other income, the combined federal and state tax hit could take about 37% of their gain. They’d have that much less for their new home purchase. For a single homeowner, the tax bite is even worse.
California taxes capital gains at the same rates as ordinary income. Add the proceeds of a home sale to your other income and presto, you’re “the wealthy,” if only for fifteen minutes after the close of escrow. California taxes “the wealthy” at the highest state income tax rates in America. You could find yourself paying 13.3% on the capital gain from your home sale and on your other income.
An older homeowner who plans to leave the home to his or her heirs has another option. He or she can keep living there until the Grim Reaper says otherwise, and then the heirs inherit the home with what is called the “step up” in the basis used to calculate capital gains. In other words, the heirs acquire the home with the current market value as the “purchase price,” and when they sell it, the capital gain is the difference between the sale price and the value at the time they inherited it. The original purchase price from decades earlier is irrelevant.
You see the problem. Our tax laws are almost forcing older homeowners to stay in their 3- and 4- and 5-bedroom homes located close to work and schools, even if they would really like to move.
This can be fixed in a way that would make everybody happy. Retired homeowners could move without a huge tax bill. Young families would find more homes on the market in the places they want to live. Government would collect revenue from the organic growth of the economy as people cheerfully moved to the location of their choosing and voluntarily spent money in the process.
One way to fix it is to restore the “rollover” of capital gains taxes that was removed in 1997. Another thing that would help is to increase the $250,000/$500,000 exclusion to restore the real value it had in 1997. It’s also possible to index capital gains to inflation for the sale of principal residences, if not for all assets. After all, the government collects no taxes on capital gains if people don’t sell the asset and realize those gains. In the case of homes, the choice of whether to sell has an enormous impact on people who are waiting to buy, and on their children, and on the finances of school districts with declining enrollment.
Some people can see it, and some people can’t. One person who can is Assemblyman Alex Lee, the San Francisco Democrat who is the author of Assembly Bill 2394, introduced in February. The bill would make capital gains on the sale of a principal residence deductible for older homeowners selling their longtime home.
One person who can’t see it is the analyst for the Assembly Revenue and Taxation Committee, who wrote that the bill appears to “largely reward activity that is already going to be taken by wealthier taxpayers” and would constitute a “tax expenditure.” That’s what fans of higher taxes call laws that fail to seize all of someone else’s money. They consider a tax reduction to be a form of government “spending.”
Some people think Proposition 13 prevents older homeowners from selling and moving, but that’s not true. Homeowners over age 55 can transfer their “Prop. 13” base-year value to another home and maintain their lower property tax bill.
If capital gains taxes didn’t prevent homeowners from selling, the homes they sold would be reassessed to market value, as Prop. 13 requires, when new owners buy them. The sale price becomes the base-year value for the new homeowners. This reset means higher tax revenue for the local government, while the new owners are protected by Proposition 13 going forward – the assessed (taxable) value can increase no more than 2% per year while under the same ownership.
The increase in home values has been astronomical. From Redfin: a 3-bedroom in Agoura Hills that sold for $275,000 in 1989 is valued at $1.2 million; a 4-bedroom, 1,700-square-foot house in Santa Barbara that sold for $915,000 in 2019 is worth $2.7 million; a 4-bedroom house in Mission Viejo, 1,460 square feet, sold for $78,000 in 1977 and will cost you $1.1 million today.
These are typical California homes. It’s long past time to recognize that inflation has pushed ordinary people into a tax situation they were never supposed to face.
This is easy to fix. Be not afraid.
Write Susan@SusanShelley.com and follow her on X @Susan_Shelley