On July 22, in response to a reporter's question, President Trump said that his administration is “thinking about no tax on capital gains on houses.” This builds on his “no tax on . . .” agenda that recently saw “no tax on tips” and “no tax on car loan interest” signed into law through the One Big Beautiful Bill Act (OBBBA). While the stated goal of the proposal is to provide relief to taxpayers during a housing crunch, a better approach would be to index all capital gains to inflation, which would prevent taxpayers from paying for illusory gains.
Current Law
Currently, the sale or exchange of a primary residence is only subject to income tax if the gain exceeds $250,000 for single filers or $500,000 for married filers. To qualify for this exclusion, the homeowner must have occupied the residence for at least two of the past five years prior to the sale or exchange. Homeowners are only eligible for the exclusion once every two years. This exclusion, created by the Taxpayer Relief Act of 1997, replaced a capital gains deferment for homeowners purchasing a higher value home that had been law since 1951 and an exclusion for older homeowners that had been law since 1964.
This exclusion eliminates the capital gains tax burden for millions of homeowners, reducing income taxes in Fiscal Year 2022 by $40.3 billion. It has grown sharply, as it was estimated to reduce taxes by $5.6 billion a year when the provision was first signed into law. The overwhelming majority of home sales are within the exclusion: only 15% of sellers experience a capital gain over the $250,000/$500,000 cap on their sale, according to the National Association of Realtors.
Despite the intent of helping middle-class taxpayers avoid a huge tax bill on what is, for many, intended to be the bulk of their retirement savings, homeowners can claim the exclusion as frequently as every two years. This structure incentivizes “home flipping” and speculative investment in the housing market, not long-term home ownership. When paired with demand-side pressures like the mortgage interest deduction, many have questioned how much federal tax policy had to do with the 2008 housing bubble.
Further home sale capital gains tax relief would primarily benefit wealthy homeowners in high-income states. Many of these states are the same high-tax blue states whose taxpayers will benefit from the recent quadrupling of the state and local tax (SALT) deduction by OBBBA. California has 25% of all U.S. homes that have appreciated in value by more than $250,000 since they were last sold, and 37% of all U.S. homes that have appreciated in value by more than $500,000 since they were last sold. Homeowners in Florida, New York, Washington, and Massachusetts would also see large tax-free gains from this proposal.
Several members of Congress have already introduced bills this year to eliminate or raise the existing exclusion. A bipartisan group of representatives has introduced legislation to raise the exclusion to $500,000 for single filers and $1,000,000 for married couples. Representative Marjorie Taylor Greene (R-GA) has introduced a bill to eliminate capital gains tax for home sales entirely, mirroring President Trump’s proposal.
Is the Issue Capital Gains, or Illusory Capital Gains?
Much of the gain from the sale of a home is inflation. For example, a sale of a home purchased for $250,000 in 1990 and sold for $750,000 this year appears at first glance to represent a significant gain, but nearly three-quarters of the $500,000 appreciation on that home is attributable to inflation. For a single taxpayer, nearly half of the resulting capital gains tax bill after the $250,000 exclusion would be a tax on inflation.
This is true of all forms of capital gain subject to tax, yet only the sale of a home has such a substantial capital gains income tax exclusion. The exclusion’s existence is likely a nod to the fact that homeownership is inextricably tied up with middle-class retirement planning in America. Most of taxpayers’ overall capital gains tax liability comes from other sources of gain. In 2015, the most recent year for which data is available, capital gains for homes only accounted for 1.2% of all capital gains reported on individual income tax returns. Nearly two-thirds of capital gains taxes paid by individuals stem from sales or exchanges of corporate stocks. Yet none of these other forms of capital gains enjoy such a substantial tax exclusion.
If fairness means avoiding tax on illusory gains, particularly gains from the sale of a primary residence, uncapping the exclusion would not truly address the problem.
Uncapping the Exclusion Is the Wrong Medicine
The current capital gains exclusion for home sales benefits short-term home investors far more than long-term homeowners. A home flipper selling a home he bought two years ago with a windfall gain receives the same exclusion as the retiree selling the home he lived in his whole life. But while the home flipper’s capital gain is composed almost entirely of real value, the retiree’s is probably substantially illusory and attributable to inflation.
While speculative home flipping’s role as a cause of today’s tight housing market is often overstated when compared to more fundamental drivers like decades of underbuilding and overly restrictive zoning, that does not mean that the federal government should be incentivizing this behavior through the tax code.
In fact, current government policies can be a major deterrent of homeownership. Taxes alone can represent around 40% of a homebuyer’s total closing costs. In 2019, Congress passed a law to relieve some of the federal tax burden for homebuyers through Private Mortgage Insurance (PMI) deductibility. This provision has since expired, but served as a successful risk transfer tool that shielded Americans from billions in potential liabilities.
Taxation of illusory capital gains due to inflation is an issue that extends well beyond capital gains in housing. The lack of indexing for inflation in capital gains means that the tax code is biased against saving and long-term investment. Ending this bias by indexing all capital gains to inflation would solve this problem without further incentivizing the treatment of housing as an investment.
If lawmakers prefer to look solely at the treatment of capital gains in the context of the exclusion, accounting for inflationary gains would be a better approach than eliminating the cap entirely. Increasing or eliminating the cap on the exclusion will disproportionately benefit short-term homeowners, while inflation indexing will better target tax relief to long-term homeowners.
Therefore, indexing capital gains to inflation and leaving the $250,000/$500,000 cap in place would be a better solution than eliminating the cap entirely. Doing so without reducing the cap or eliminating the exclusion entirely would exacerbate the tax code’s disproportionately favorable treatment of housing investment compared to investment in other assets, but less than eliminating capital gains tax on home sales entirely.
On the other hand, it would help alleviate the advantages that home flippers have over long-term homeowners. Congress could also consider reducing the frequency that a seller is eligible for the capital gains tax exclusion for home sales from once every two years to once a decade.
Conclusion
Lawmakers are right to try to address the problem of taxpayers paying tax on inflationary gains, but wrong to focus on housing to the exclusion of other types of capital gains. Taxing inflationary gains has never made sense from a policy perspective, as it punishes savers and long-term planners. There is little reason to try to solve this broader problem with a tax break that is hyper-targeted to wealthy home flippers.
Instead, lawmakers should look at indexing all capital gains to inflation. Failing that, indexing capital gains on home sales to inflation while leaving the cap in place, as well as requiring longer periods of time before a taxpayer can claim the exclusion again, would help address the tax code’s bias against long-term homeowners.