Taxes and the Housing Boom

This argument has been heard before and it is now popping up again:

One of the main reasons for the housing boom in recent years is the Clinton Taxpayer Relief Act of 1997.

If you'll recall, this is the tax code change that turned home equity gains of up to $500K into "tax free" gains, as long as you lived in the residence for two of the last five years before the sale (the $500K maximum is for couples - there is a $250K limit for singles).

Does this make sense? Could this tax code change be contributing in a big way to the housing mania? Let's look at two recent sources for this line of reasoning.

In Christopher Farrell's latest missive he notes:

What accounts for the housing boom? Economists have cited a number of fundamental factors, including low interest rates, favorable demographics, and restrictions on development. But the unappreciated force that may have infected a strong housing market with home-buying mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act of 1997, signed by Bill Clinton.

And this, from one of our favorite economists, Larry Kudlow:

Upward price momentum has kicked into higher gear in recent years for two important reasons. First, housing is highly tax-advantaged. The 1997 tax-cut bill — proposed by a Republican Congress and signed into law by a Democrat president, Bill Clinton — permitted the first $500,000 of profits from the sale of a home to be tax-free. This came on top of existing law that permits mortgage expenses to be tax deductible depending on one’s income bracket.

These supply-siders agree that somehow the 1997 tax cut has contributed in a big way to skyrocketing real estate prices, but how? The previous law required gains to be reinvested in a higher value residence within two years in order to avoid paying taxes. There was also a one-time exclusion if you were over the age of 55 - this was designed to help retirees relocate to less expensive areas without incurring a big tax bill.

Ahhh, memories. Back in the nineties we would occasionally hear stories about someone who was about to retire and move away from Southern California with a pile of cash from the sale of their home. They had lived in that home for the last 20 years and they only owed another $15K on it, and they were going to sell it for $245K. That was a pile of cash back then - those numbers are almost comical by today's standards, and it wasn't that long ago.

But we digress...

It seems that if anything, this tax law and today's real estate prices would encourage more people to sell than to buy. As discussed in yesterday's post, some people are "cashing out", taking advantage of these tax free gains, then waiting patiently for prices to return to more normal levels.

Whether or not this will work out for them, we don't know. But, on the face of it, for the average homeowner, the 1997 tax law change is an incentive to sell in the bubbly areas, not buy.

It is understandable how real estate investors could move from house to house every two years, fixing one up then selling it at a hefty tax-free gain before moving on to the next one, but surely this cannot explain much of the real estate craziness of recent years.

One person, one house, two years - that doesn't sound like a mania.

Most recent accounts of investor behavior describe individuals buying property to rent out at a loss for a year or two, then sell for a profit. This would not be eligible for the tax-free status, nor would the activity of "flippers", who sell long before the minimum two year period.

Does the 1997 tax law simply encourage people to buy with the expectation of selling sometime in the future with a huge tax free gain? And then what? Move to another state?

Does this supply-sider argument make sense to anyone?