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Tax Expenditure of the Week: Tax-Free Capital Gains for Primary Residences

Counting Down the Country’s Biggest Tax Breaks, Week by Week

SOURCE: AP Photo

In this photo taken March 16, 2011, a "sold" sign hangs in front of a house in Albany, New York.

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This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.

Subjecting these dozens of tax code programs to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.

This week we’re looking at the capital gains tax exclusion for people who sell their homes—a substantial tax expenditure that will cost $35 billion in fiscal year 2012.

What is the capital gains tax exclusion for home sales and how does it work?

When you sell property that has appreciated in value, you generally pay capital gains taxes on the gain. But there is a special rule for home sales. When property owners sell their primary residences that have appreciated in value, a big part of the gain is exempt from taxation: up to $250,000 in gain for individuals and up to $500,000 for couples.

This rule is one of several ways the tax code subsidizes owner-occupied housing. It also inflates home values because it means that investments in homes get a better after-tax return than other investments—raising the price that future buyers are willing to pay.

Why is this a tax expenditure?

This type of subsidy is called a tax expenditure because it’s essentially a government spending program for housing that happens to be administered by the IRS. Tax expenditures are special rules that subsidize certain taxpayers or activities while reducing revenue to the U.S. Treasury.

How much does it cost?

The capital gains tax exclusion for principal residences will cost the federal Treasury $35.2 billion in the coming fiscal year and $217 billion over the next five years.[1]

The capital gains exclusion on home sales is the second-largest housing tax expenditure, behind the deduction for mortgage interest. The huge cost of these programs underscores the fact that the nation’s housing policy is largely shaped through the tax code, not just by direct spending programs. And yet direct spending programs in housing tend to receive far more attention and scrutiny, and have been targeted for cuts by the House of Representatives’ spending bill for the current fiscal year.

Tax expenditures vs. direct spending

What’s the rationale for a special tax break for home sales?

Home sales have received special tax treatment for more than 50 years.[2] The exclusion is intended to reduce or eliminate a tax bill that would otherwise come due when homeowners sell a house to take a new job, retire, or adjust to other circumstances.[3] It may therefore increase labor force mobility. There’s also an administrative rationale: The tax break reduces the burden on taxpayers to document how much they’ve spent acquiring and improving their homes.[4]

Who benefits from this tax expenditure?

The tax exclusion on home sales is one of several substantial federal subsidies for owner-occupied housing. In fact, 92 percent of all housing tax subsidies support owner-occupied housing while only 8 percent support rental housing, according to a new analysis by the Pew Charitable Trusts. By contrast, 73 percent of the far-smaller direct spending programs on housing support rental housing.

Distributional data on the capital gains exclusion for home sales is not readily available, but by definition this tax expenditure benefits homeowners who realize substantial gains on home sales. The larger the gain, the bigger the tax benefit, up to the $250,000 and $500,000 limits. In previous installments of this series, we explored how the mortgage interest deduction and property tax deduction provide “upside-down” subsidies for homeownership, benefiting wealthier taxpayers with more expensive homes. The exclusion of capital gains on home sales reinforces the upside-down nature of housing tax expenditures.

How has this tax expenditure changed recently?

The capital gains exclusion for home sales was significantly reformed in 1997. Home sellers before then were allowed to defer capital gains taxes on the gain if they subsequently purchased another home. And sellers over age 55 were permitted a one-time exclusion of $125,000. This treatment created economic incentives that “distorted” choices people might otherwise make. For example, people under age 55 who sold their homes would only get the tax break if they bought another, bigger house rather than “downsizing” or renting.[5]

The current tax exclusion of $250,000 for individuals and $500,000 for couples replaced these two provisions. Today, you don’t have to buy a new home to replace the old one or be over age 55 to qualify for the tax exclusion. But you do have to have owned and occupied the property for two of the last five years.[6]

The 1997 changes are widely viewed as a reform that simplified the tax code and made it more efficient. But the rule that restricts the exclusion to people who have lived in their property for at least two of the last five years has been criticized for encouraging people to “flip” houses to enjoy tax-free gains, thus contributing to the housing bubble of the last decade. While many experts doubt the 1997 reform was a significant cause of the housing bubble, the rule could be tightened to prevent flipping by lengthening the period a taxpayer must live in the property to qualify for the tax exclusion.[7]

In reviewing federal budget priorities, policymakers should recognize that the nation’s largest housing programs are those administered by the IRS. And these tax expenditures deserve to be evaluated alongside direct spending programs for their cost-effectiveness in advancing our nation’s housing goals.

Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.

Endnotes

[1]. Office of Management and Budget, Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2012 (Executive Office of the President), table 17-1.

[2]. Jane G. Gravelle and Pamela J. Jackson, “Exclusion of Capital Gains for Owner-Occupied Housing” (Washington: Congressional Research Service, 2007).

[3]. Ibid.

[4]. Another justification for the exclusion is that part of the gain on one’s home represents gain from inflation, rather than gains in real terms. But the tax code also does not require homeowners (or businesses that borrow funds) to adjust their interest deductions for inflation.

[5]. Len Burman, “Did the Capital Gains Tax Break on Home Sales Help Inflate the Housing Bubble?”, TaxVox, December 22, 2008, available at http://taxvox.taxpolicycenter.org/2008/12/22/did-the-capital-gains-tax-break-on-home-sales-help-inflate-the-housing-bubble/.

[6]. The exclusion is no longer a one-time tax benefit, as it was before 1997. There is no limit on the number of times a taxpayer can claim the exclusion, though it can’t be claimed more than once during any two-year period. See: Internal Revenue Service, Selling Your Home (Department of the Treasury, 2010), available at http://www.irs.gov/pub/irs-pdf/p523.pdf.

[7]. President Bush’s Advisory Panel on Tax Reform proposed to require residence for three out of five years, but the proposal has not been acted upon. See: The President’s Advisory on Federal Tax Reform, “Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System” (2005), p. 74, available at http://govinfo.library.unt.edu/taxreformpanel/final-report/index.html.

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