THE TAXPAYER RELIEF ACT OF 1997 AND HOMEOWNERSHIP: IS SMALLER NOW BETTER?

I. INTRODUCTION While there is a lengthy literature on the U.S. Tax Code's mortgage interest deduction and property tax deduction, less attention has been paid to the capital gains tax treatment of owner-occupied housing. Prior to 1997, the U.S. Federal Income Tax Code allowed home sellers to roll over capital gains taxes from the sale of a home if they bought up--that is, if they purchased another house within 2 years that was at least as expensive as their previous home. In 1996, the U.S. Office of Management and Budget (OMBA) estimated tax expenditures of $14.4 billion from this deferral (rollover) of capital gain taxation. Home sellers over the age of 55 were treated differently than those under 55 as they received a one-time capital gains tax exclusion from the sale of an owner-occupied home of up to $125,000, a tax expenditure of $5.2 billion. (1) To give some perspective, the tax expenditure associated with the deductibility of state and local property taxes was estimated to be $15.9 billion, and the expenditure from the deductibility of mortgage interest payments was $47.5 billion in 1996. (1) The passage of the Taxpayer Relief Act of 1997 (TRA97) eliminated the differential treatment of home sellers over and under the age of 55. After 1997, the first $250,000 ($500,000) in capital gains from the sale of a single (married) owner-occupier's primary residence is tax exempt, regardless of the home seller's age and whether they purchase more or less housing following the sale of their residence. For most home sellers, this effectively eliminates capital gains taxation from the sale of a primary residence, as the median home price was less than the exclusion amount. (2) In addition, TRA97 lowered the marginal tax rate applied to long-term capital gains from any assets, including housing. Incentives created by the Federal Tax Code prior to 1997 for home sellers under the age of 55 to purchase a more expensive house than their previous one, or "buy up," to defer capital gains taxes have been of particular interest to economists. If, instead, a home seller bought a less expensive home, or "bought down," and had a capital gain, taxes were paid on the difference between the values of the two homes up to the maximum of the capital gain. Thus, for home sellers, incentives to buy more expensive homes were created. In addition to the incentive to buy up, the differential tax treatment of home sellers under 55 from those older than 55 may lead to a lock-in effect--the incentive for a homeowner under 55 to defer selling her home if she desires a less expensive one, consistent with Shan (2011). This creates "mismatch" in the housing market as homeowners choose to reside in homes that no longer reflect their housing demand in an effort to avoid taxation of capital gains. This being the case, the post-TRA97 taxation of capital gains is expected to increase the likelihood that a homeowner younger than 55 moves to less expensive housing. While it is true that home sellers over the age of 55 were affected by TRA97, as it increased the level of capital gains exempt from taxation and lowered capital gains tax rates, we do not expect the impact of these changes to lead to as significant behavioral changes for home sellers older than 55 as the behavioral changes for those under 55. (3) Exploiting the fact that TRA97 differentially affects those over and under 55 allows identification of some of the effects it has had on the housing market. Specifically, this allows us to see if home sellers under the age of 55 who are no longer locked-in to their current level of housing consumption bought less expensive housing, or "moved down" after 1997, reducing mismatch. Rather than focusing on all home sellers under the age of 55 to provide better comparison with home sellers over the age of 55, we focus on home sellers between the age of 50 and 54 and compare with home sellers between the ages of 56 and 60. …