Baby-Boomers Profit at Gen-X’s Expense

When young people purchase a first house, tax policy plays a central role in this milestone event, particularly after passage of the Tax Relief Act of 1997 (TRA’97).

Before that law was enacted, U.S. tax law allowed people under 65 who sold their principal residence to avoid taxes on any profit--but only if they bought a replacement home of equal or greater value within two years. TRA’97 threw out the “more expensive home” requirement, replacing it with a high ceiling on the amount of gain that could be deducted: $250,000 for an individual, or $500,000 for a couple. To make the benefit even greater, it also reduced the maximum tax rate on capital gains from 28 to 20 percent.

Those provisions gave existing homeowners huge tax savings. For example, consider Chris and Sandra: a couple, both 50 years old, together earning $90,000. Suppose they sell their primary residence for a profit of $100,000 and move to a rental, or to a small town where housing is inexpensive, or to a second home they already own. In all these cases, they would have owed substantial taxes before 1997 ... but now they would pay no tax on the home sale because the profit was less than $500,000.

Thus, the Tax Relief Act of 1997 made housing investments dramatically more profitable, shifting demand from other investments to housing, and raising home prices. The main beneficiaries of this change are empty-nest baby-boomers, those homeowners who are not yet 65 but whose children are old enough to move away from home. (The home sales of older couples over 65 were always tax-exempt.) These baby-boomers can now downsize their homes without a tax penalty, and that makes their existing homes more valuable.

Younger families do not benefit from the new law nearly as much. They are typically shopping for relatively large houses to accommodate growing families, so the old “more expensive house” requirement wouldn’t have bothered them. Thus, the change in how home sales are taxed will benefit them very little, at least in the near term, but it did raise the prices of the houses they’re shopping for.

Thus, TRA’97 has essentially resulted in a significant transfer of wealth from young couples buying their first house, or upsizing their housing needs, to pre-retirement empty nesters.

Certainly, the new tax benefit is not the only factor driving up home prices--mortgage interest rates have been at historic lows. But even after taking mortgage rates and other factors into account, TRA’97 boosted existing home prices as much as 13.7 percent above what they would have sold for.

Bill Ahern is communications director of the Tax Foundation.
http://www.taxfoundation.org

For more information ...

Affordable Housing: An Action Agenda for State Legislators. Three public policies--zoning, building codes, and property taxation--significantly affect the availability of affordable housing in a community. Reform of these policies, plus tenant ownership or management of public housing, is called for. (The Heartland Institute, 1991)

Go to www.heartland.org and use PolicyBot to request document #3816.