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Did 1997 Capital Gains Tax Exclusion for Housing Contribute to Economic Crisis?

2 min readBy: Joseph Bishop-Henchman

Economists posting on the Cafe Hayek blog have been dissecting the $700 billion bailout proposal, discussing various causes and possible steps to be taken during the current economic situation. Professor Russ Roberts, quoting Nobel Prize winner Vernon Smith, notes that a 1997 taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. change had much to do with the run-up in housing prices:

[I]n 1997, the tax on capital gains for housing was dramatically relaxed.[… The change allowed you a] $125,000 tax exclusion on capital gains for home owners older than 55 and the "rollover" law that allowed you to defer paying capital gains taxes provided you purchased another, more expensive home in time.[…] The relief act's primary provision for home sellers is the capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. exclusion — when you sell your home, if you qualify, you can keep, tax free, capital gains of up to $500,000 if you are married filing jointly or $250,000 for single taxpayers, or married taxpayers who file separately.[…]

Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.

This is of course just one example of how our tax code subsidizes housing over other economic decisions through distortionary and generous treatment; other examples include the mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. and now the first-time homebuyer credit. Roberts continues on to quote Chris Farrell from Business Week in 2005:

[C]apital gains on stocks and bonds carry a 15% levy (the capital gains tax rate had been 20% until the tax law change of 2003.). The powerful lure of tax-free profit is one reason that home prices have risen at a nearly 7% annual rate, vs. about 4% for the stock market since 1997. Sell a home with a $500,000 profit and owe Uncle Sam nothing. But realize a $500,000 gain on and the federal government takes 15%. That's the kind of math most people can figure out.

The issue goes way beyond tax fairness. A growing number of economists are deeply concerned that residential real estate is absorbing far too many economic resources. Money is pouring into concrete foundations rather than high-tech innovation. "Residential investment accounted for 35% of private investment in the past year, a level not seen since the early 1970s," notes Martin Barnes, the perceptive financial-market observer at Bank Credit Analyst.

The New York Times published this graphic of the Case-Shiller housing index (note, as of August, the index has dropped further to 155). Think housing prices have hit bottom?

Case Shiller Index

Search the Tax Foundation website for "housing" to see some of our extensive commentary on the topic.