by Calculated Risk on 7/11/2005 01:31:00 AM

Also: Please see my most recent post on Angry Bear: Help Wanted: Real Estate Agents

Housing: The Tax Myth

Various people have suggested that the current Real Estate boom is a direct result of the Tax Relief Act of 1997. The Tax Relief Act was sponsored by Rep John Kasich (R-OH) that replaced a similar senate Bill sponsored by Senator Roth (R-DE). Although the Bill was Republican sponsored, it passed the Senate 92 - 8 and the House 389 - 43 and was signed into law by President Clinton. Obviously the Act had widespread bipartisan support.

The '97 Act made a major change in how gains on primary residences are taxed. Under the old law, gains could be rolled over into a new home, as long as the home was of equal or greater value than the old home. Once a homeowner (or their spouse) reached the age of 55, they could take a one time exclusion up to $125,000 of the profit from the sale of their residence to "step down" and buy a smaller home. NOTE: I'm outlining the standard rules and skipping all complications.

Under the new law, homeowners receive a $250K (single) or $500K (married) tax exclusion when they sell their home. They can use this exclusion every two years. The old "rollover" and 55+ year old rules no longer apply. Some people have argued that this exclusion is responsible for the real estate boom.

What would motivate someone to take advantage of the exclusion? Here is the simple case: A married couple buys a home for $400K and some time later the house could be sold for $800K. Should they sell to take advantage of the $500K exclusion?

Assumptions: Property taxes are 1% (added: California Law). Transaction costs are 6%.

Here is the argument some people are making: To take advantage of the exclusion, this couple would sell their home for $800K and buy a similar home for $800K. They would have to take out a loan for $48K more on the new home to cover the transaction costs and their property taxes would increase from $4K per year to $8K per year. For doing this transaction, their basis on the new house would be $800K (as opposed to $400K under the old law). This new basis would save the couple from paying capital gains in the future on $352K ($400K minus $48K) or taxes of $70K (if taxed at 20% capital gains).

What is the better deal: 1) To have a $48K immediate increase in debt plus payments of $4K more per year or 2) to have a future tax liability of $70K? For most situations the answer is #2, so the Tax Relief Act of '97 isn't motivating people to buy and sell similar properties.

Is there an example of where the '97 Act would motivate people to buy and sell? If homeowners are moving down in price (moving to a smaller property or moving to a less expensive state or even renting) then the Act might be contributing to the boom. Is there evidence of homeowners en masse moving to renting? No, the opposite has happened. Is there evidence of homeowners moving to smaller homes or less expensive areas? Not a significant number. Besides this would drive up the prices in less expensive areas and lower the price in expensive areas - is that what is happening? No.

The bottom line is the Tax Relief Act of '97 is not contributing to the bubble as some people suspect.

However, there is one impact that might be happening in more expensive areas. Long time homeowners over 55, with significantly more than $500K in equity, might not move to less expensive housing to avoid paying taxes. This might reduce inventories of expensive homes, but I doubt this is a widespread problem.