When Tax Changes Turn Your First Home into Your Forever Home

Both the House and Senate tax reform bills increase the number of years homeowners must live in their primary residence in order take advantage of the capital gains exclusion. Tens of millions of Americans have benefited from the capital gains exclusion when they sell their home to house an expanded family, to down size, to move for a job, and to build wealth for retirement. Furthermore, investment in homeownership is the main driver of wealth for most families. Adding onerous requirements to the capital gains exclusion will have negative impacts for homeowners and will not help fund tax cuts.

Currently, if an individual or family owns a home and lives in the home as the primary residence for at least two of the previous five years, capital gains on the sale of the home is exempt from taxes. This means that if a homeowner needs to sell her primary residence after three years, for example, to buy a larger home to house a growing family, she can sell her home and use all of the profit from the sale as a down payment for the next home. According to NAR’s Profile of Home Buyers and Sellers, 54 percent of trade-up buyers use equity from their prior home for their down payment.

Under both House and Senate reform proposals, individuals and families would need to wait at least five years before they could sell their homes and keep all their equity. Otherwise, they will pay a steep capital gains tax on the growth in the value of their homes. Since this change to the capital gain on sale would hurt homeowners’ ability to reinvest in their next homes, it would fundamentally raise the risk of the trade-up process. Millennials will need to choose wisely, as their first home may be their forever home.

In the short-run, some affected sellers are likely to hold their homes back from the market exacerbating current low levels of entry-level inventory. Over time, most of these owners will sell, but some will opt not to trade up. This change will have economic and tax effects and hold back a portion of the housing stock.

As outlined in an earlier post, 10 percent to 22 percent of owner occupied home sellers owned their home from two to five years according to NAR’s Profile of Home Buyers and Sellers (2016). Similarly, Black Knight Financial Services, estimated that more than 14 percent of recent sellers owned their homes for two to five years¹. If 14 percent of buyers fall into this expanded capital gains definition, then roughly 620,000 home sales would be affected annually. If over the long-term just 5 percent of these affected buyers chose to forgo a trade up purchase, more than 30,000 home sales per year would not occur.

In 2016, NAR estimated that the typical home sale resulted in $64,000² worth of economic activity from services, remodeling, appliances, fees, new construction, the housing wealth effect, and an economic multiplier. This means that the reduced home sales would lower gross national product by roughly $2.0 billion each year. Assuming a tax rate of 15 percent, this would result in revenues falling by roughly $300 million each year. The Joint Committee on Taxation estimated that changing the tenure period of the capital gains exemption would raise for the Treasury $800 million over ten years as the IRS collects taxes on more home sales³. This estimate does not account for the dynamic loss of economic activity and the $300 million in annual tax revenues that dwarf the $80 million “saved” each year by this change. If the share of affected sellers rises to 17 percent, the average of the NAR estimate, or if the share of owners who opt not to trade up rises, the economic effect could be a loss of $7 billion in annual activity and $1 billion in tax revenues. Worse, if homeowners alter their behavior and stay five or more years, the IRS would receive no revenue from the capital gains change, yet the economic effects and long-term decline in turnover would remain. Even worse, the negative effects outlined here do not account for the drag on labor mobility or the negative wealth effect from a drop in or drag on price growth.

The capital gains exemption has worked well for nearly two decades. If tax writers are concerned about flipping behavior there are other means to address this issue than hurting the economy and the average American’s Main Avenue for building wealth.