Just when you think things couldn’t get worse for California’s beleaguered taxpayers, a new problem is beginning to emerge that will surprise many homeowners when they sell their primary residences. The problem is the result of both rapidly rising home values and the failure of our political leaders to enact inflation adjustments to the capital gains exclusion on the sale of homes.
Let’s start with inflation.
Inflation under the Biden presidency inflicted a great deal of pain to most Americans. During that four year period, the cost of food (especially eggs), energy, and housing went up over twenty percent. As this column has argued previously, inflation is the cruelest tax of all.
As punishing as inflation was nationally, California felt even greater pain. According to National Business Capital, “the most impacted states, however, were California and New York, which suffered from a potent combination of decreasing wages (when adjusted for inflation) and large price increases from 2021 to 2022.”
The rapid rise in housing costs was particularly acute. In the last four years, the U.S. housing market has experienced a 47% increase in prices according to Business Insider (May 10, 2024). But, as one can expect, California is much worse than the national average in housing costs.
For existing homeowners, particularly those who are locked into lower interest loans, the rapid increase in housing costs has been mostly beneficial. Home equity, nationally, has increased 80% since 2020 due to rapid increases in home values. This approximately $19 trillion in new wealth adds to the personal balance sheets of Americans lucky enough to own homes. As of 2024, this rate of increase was about twice the rise in financial wealth from other investments including stocks and bonds.
But as a recent Wall Street Journal article pointed out, there are downsides to rapid increases in home values, including higher property taxes. (Fortunately, that is much less of a problem in California which limits annual increases in assessed value to two percent.)
For homeowners who are planning to sell their primary residence in the near future, there is a growing concern that the proceeds from the sale could be sharply reduced by state and federal taxes on capital gains. Although there is a general awareness of a capital gains exclusion, the value of the exclusion has been severely eroded due to inflation. The assumption that the sale of a primary residence won’t result in capital gains tax liability might prove to be more myth than reality.
That’s because the rapid increase in home equity has created more instances where the maximum home sale gain exclusion amounts under the Internal Revenue Code may be surpassed and result in taxable gains. Currently, under Sec. 121(b), the exclusion is up to $250,000, or if married filing jointly, $500,000. (California tax law conforms to the federal standard).
Importantly, these exclusion amounts have not been indexed for inflation and have remained at $250,000/$500,000 since 1997.
Here are the details of the current exclusion. The IRS Code allows a taxpayer to exclude from gross income a limited amount of gain on the sale or exchange of property that, during the five-year period ending on the date of the sale or exchange, has been owned (ownership test) and used (use test) by the taxpayer as the taxpayer’s principal residence for periods aggregating to two years or longer (Sec. 121(a)). In addition, the exclusion generally can be claimed only once every two years (the lookback requirement) (Sec. 121(b)(3)).
It’s important to keep good records of improvements to the property, because the money spent on remodeling and other changes may add to the cost basis, reducing the capital gains and the taxes owed when the property is sold.
Homeowners are advised to consult their tax professionals prior to selling their primary residence as well as deciding how much to spend on their replacement residence. In the meantime, pressure needs to be applied to both Congress and the California Legislature to increase the exclusion as well as include an inflation factor moving forward.
Jon Coupal is president of the Howard Jarvis Taxpayers Association.
