Many cities today face the challenge of increasing the availability of affordable housing. The common approach is to find ways to generate more new housing. That usually involves municipal or state subsidies or tax breaks for land and development. A recent analysis by Moody’s Analytics suggests there may be an additional way to address this problem.

In 2000, according to the Los Angeles Times, a near-record 493,000 existing single-family homes were sold in California. By 2023, the California Association of Realtors reported that existing home sales had dropped to nearly half that amount (258,000). This is even though the mortgage rate back then was over 8% but less than 7% in 2023. Of course, there are many factors other than interest rates that impact existing home sales. Mark Zandi and Cristian deRitis at Moody’s, in a report titled “Capital Gains Taxes and the Misallocation of Housing,” assert that one major cause is federal capital gains tax policy.

According to the report, the Census Bureau found that the average square footage (sf) of a home per capita in the U.S. is 700 sf. Based on that, the average home size for a family of two would be expected to be around 1,400 sf, for a family of three 2,100 sf, and 2,800 sf for a four-person family. But that’s not how the data breaks down. There are actually 3.5 million homes larger than 2,500 sf occupied by only one or two seniors aged 65-74 and another 2.3 million owned by seniors aged 75 and older. That’s almost six million houses that could be utilized more efficiently by larger families.

One of the reasons younger homeowners are often reluctant to sell their homes is because they are holding onto mortgages with rates significantly lower than current rates. But most older homeowners have paid off their mortgages or have only small balances remaining. Why aren’t they downsizing from homes that are not only bigger than they need but frequently require more work to maintain? The report blames the high capital gains taxes associated with senior home sales. The Taxpayer Relief Act of 1997 established an exclusion of $250K for single taxpayers or $500K for married taxpayers from taxes on the gains from home sales by taxpayers over age 55. At the time this was a high enough threshold that few people faced significant taxes. But over the nearly three decades since then, home prices have risen 250% on average across the U.S. but this exclusion amount has not changed at all.

The report suggests that if the capital gains tax exclusion for senior home sales were to be increased to $885K/$1.775K, matching average housing price inflation since 1997, more seniors would be open to downsizing or to moving into senior living facilities. They cite research suggesting not only the improvement in housing liquidity from this change but also economic benefits such as reduced regional unemployment.

Zandi and deRitis also identify possible ways to cover the estimated $6 – $10 billion in lost federal tax revenue from such a change. Whether or not the Trump administration would consider such an attempt to further modify tax revenues is anybody’s guess.

The report does not directly address another goal of seniors, namely passing on their homes to their children tax free due to the step-up in basis when they die. It’s not clear how much that goal overrides seniors’ reluctance to sell homes due to the capital gains tax exclusion.

The cost of housing in many locations in this country is a complex problem that municipalities and states are forced to deal with. Increasing the federal capital gains tax exclusion is certainly one way the federal government could contribute to helping solve the problem.

Here’s a link to the report: https://www.economy.com/getfile?q=C8D59392-75B0-4486-B9C4-3A6C8A01774E&app=download.

(Artie Green is founder of Cognizant Wealth Advisors dba Perigon Wealth Management, LLC, a registered investment advisor. For more information visit cognizantwealth.com. More information about the firm can also be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com).