Wikinvest Wire

Taxes and the Housing Boom

Wednesday, July 27, 2005

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?

9 comments:

Anonymous said...

For a while now my brother the tax guy has said that the first tax break to go would be the tax free home sale, since it is the best and for the most part only tax break for the middle class. What I see is a trial balloon on this issue. There are a few advantages to this tax change, it would greatly help with our fed deficit, it does not benefit the rich as much as it does the middle class. The rich investor can use the old 1031 tax exchange to avoid paying taxes on investment property. But the best reason of all is you can even tie the housing bust to Clinton! No it is not the low interest rates, easy money, loan requirement changes, and stock fear, no, it was Clinton!
I think the home bust will end up the same way as it did when Bush 1 deregulated the Savings and Loans, with a huge federally subsidized program to sell off the homes at rock bottom prices in a recession, where only wealth people with no job loss concerns will once again pick up the places for nothing.

Anonymous said...

Anecdotally, I have been hearing a lot about both the sale tax emeption and the mortgage interest deduction, contrasted to "sunk rent". From this I take the liberty to infer that the tax provisions do have a clear effect on people in forming future expectations and their willingness to "invest" more money in a house than in taxed investments, even if a serious economic analysis may show it's another instance of the tax tail wagging the investment dog.

Anonymous said...

I don't know how I managed to make "emeption" from "exemption" though, and failed to spot it in the proof-reading.

Anonymous said...

cm...
Owning a rental is better then your own home. Home owners get to write off their interest only. Rental owners write off interest and maintenance (which sometimes is improvements, but not supposed to be) as well as getting a 24 year strait line depreciation, and even better if you build the rental home you get around 50% first year write off. So the best tax break is building a rental, then rent it while improving it, which allows you to write off the loss against your working income. Then if the property goes up in value you can kick out the renters and move in for a few years to get the 500k tax free sale, or do a 1031 tax exchange to the next investment. If you have someone in your family or a friend that you trust, you can own their home and they can own your home for max tax write offs.
It was such a great gig before the big bubble, but now the crash risk is so great that I am sitting on the sidelines with cash waiting for the bust. The 1989 crash took about 7 years to bottom out and that was a much smaller bubble with more sound loans, so this one may be more like Japan with its 15 year decline in real estate. But a recession is great if you are cash rich, it is like a garage sale on real goods.

Anonymous said...

Good analysis, Tim. More evidence that the best side to take in any argument is the one opposite Kudlow's.

Anonymous said...

anonymous (9:53 PM): Quite a big piece of trust you will have to put forward. Families or previous bosom friends have been feuding over smaller things.

Anonymous said...

All I can glean from the tax law is that it encourages more transactions. Because it allows the seller to pocket some cash. Now, he looks around and says "what am I going to do with this?" Plus, the obligatory "where am I going to live?". So, he looks at the cash and says to himself "this will get me into that nice 3000sqft 1997 built colonial and get me an RX300". Ergo...

Is it something as simple as enabling the increased velocity of money?

Of course, this should all be prefaced with the fact that I'm less than a novice at all things RE/finance/economics.

Anonymous said...

dm: Yes, I should definitely think it encourages more transactions. But one of the opposing arguments was that the probably most common case, moving from one house to another tax-free, was already available before.

I'd say therefore the encouraging of transactions works more through the setting of expectations of future sales and superficial (?) appeal of tax-free goodies than after the fact.

Anonymous said...

I rather think that the effect of the tax exemption is over stated. First of all, it is now some 8 years since it was enacted, and it must be mostly priced into the market by now. Second, in those places where it has always been the case-Canada and Britain are two examples- it has never had an extraordinary effect on the market, they have booms and busts as though this were not a factor.( In Canada, gains from one's 'principal residence' are totally exempt-it could be for millions. Further one's only has to live in the house for 1 night to make it elegible, and the exemption can be taken repeatedly.) the 1997 exemption probably has some effect for some people, but it is probably not a major factor.

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