The Exclusion of Capital Gains for Owner-Occupied Housing

December 26, 2007 – February 2, 2022 RL32978

The Exclusion of Capital Gains for
February 2, 2022
Owner-Occupied Housing
Jane G. Gravelle
For 70 years, capital gains on sales of taxpayers’ homes have been preferentially treated. A
Senior Specialist in
revision in 1997 replaced two longstanding provisions—a provision allowing uncapped capital
Economic Policy
gains tax deferral (i.e., a rollover) when a new residence was purchased and a provision allowing

a one-time exclusion of $125,000 for sellers over aged 55—with a capped exclusion for each
sale. Although the cap adopted in 1997 was higher than the cap for the over-aged-55 sellers, it

was less generous than the uncapped rollover provision. In addition, the dollar cap was not
indexed for price changes, and, unlike the previous over-aged-55 cap, was half as large for unmarried taxpayers—$500,000
for married couples and $250,000 for single taxpayers.
Two factors in the years following the 1997 revision, (1) the rapid rise in housing prices and (2) interest in tax reform,
suggested the capital gains exclusion, including the dollar cap, might be reconsidered. In the 109th Congress, two bills were
introduced to address this issue. H.R. 2127 would have allowed taxpayers over the age of 50 to double the current exclusion,
once in their lifetime. H.R. 2757 would have indexed the exclusion to price changes. Other legislation (H.R. 3803 and S.
4075) was introduced to change the amount of the exclusion for surviving spouses to that of a married couple. In the 110th
Congress, S. 138 was introduced to allow a surviving spouse to exclude up to $500,000 of gain from the sale or exchange of a
principal residence owned jointly with a deceased spouse if the sale or exchange occurs within two years of the death of the
spouse. That provision was enacted as part of the Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110-142) on
December 20, 2007. The Mortgage Forgiveness Debt Relief Act of 2007 had been proposed in response to the financial crisis
and downturn in the housing market. Since then, no further legislative proposals for changing the exclusion have been made.
Given concerns about recently rising housing prices and inflation in general, policymakers may wish to reconsider the
$250,000/$500,000 cap. The current treatment of capital gains could be maintained. However, some consideration might be
given to changing the dollar ceiling. One option is to eliminate the ceiling. A nother option is to adjust the ceiling for price
changes.
Some have criticized the significant tax benefits for owner-occupied housing. Capital gains treatment is one of those benefits.
Yet, there is an efficiency argument for eliminating or excluding a large portion of the tax gain on homes. Capital gains taxes
on homes create barriers to labor mobility in the economy. Imposing capital gains taxes on homes also creates significant
compliance costs, requiring individuals to keep records for decades and to make fine distinctions between improvements and
repairs. Capital gains taxes also tend to distort housing choices, discouraging individuals from selling their homes because of
changing family and health circumstances. Moreover, while the exclusion favors homeowners relative to renters, the taxation
of gains in excess of a cap creates inequities between homeowners with different job circumstances, between those living in
different parts of the country, and between those with different health outcomes. Exclusions of gains on homes do, however,
contribute to tax avoidance schemes, especially ones that allow gains on investment properties to escape tax.

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The Exclusion of Capital Gains for Owner-Occupied Housing

Introduction
For 70 years, capital gains on sales of taxpayers’ homes have been given preferential treatment. A
revision in 1997 replaced two longstanding provisions—a provision al owing an uncapped capital
gains tax deferral (i.e., a rollover) when a new residence is purchased and a one-time exclusion of
$125,000 of capital gains for sel ers over aged 55—with a capped exclusion for each sale.
Although the 1997 cap was higher than the previous cap for the over-aged-55 sel ers, it was less
generous than the uncapped rollover provision it replaced. In addition, the dollar cap was not
indexed for price changes, and, unlike the previous over-aged-55 cap, was half as large for
unmarried taxpayers—$500,000 for married couples and $250,000 for single taxpayers. The
exclusion is al owed once every two years, subject to taxpayers meeting ownership and use tests.
The cap was presumably meant to eliminate any capital gains tax on home sales for the vast
majority of taxpayers, but the rise in housing prices and the passage of time have reduced the
value of the exclusion. With no revision and an increase in housing prices, an increasing share of
gains would be subject to tax.
Housing prices fel during the financial crisis and did not regain their 2007 high point until 2013,
when they again began rising. They rose steeply during the COVID-19 recession and recovery. If
the $250,000 and $500,000 values had been increased to reflect the change in the average housing
price between 1998 and 2021, they would now be approximately $650,000 and $1,300,000,
respectively; if they had been increased to reflect the median housing price by 2021, they would
be $700,000 and $1,400,000, respectively.1 If they had been increased to reflect the general price
rise in the economy (the gross domestic product, or GDP, deflator), they would be $400,000 and
$800,000, respectively.2
This report examines the capital gains exclusion and the cap. The first section describes the
current tax rules, the second section presents the historical development of the capital gains
provisions, and the third, the coverage and cost. It then discusses potential justifications for
capital gains relief, as wel as tax avoidance problems that may arise. The final section discusses
various options for change, primarily focusing on the dollar ceiling.
Current Tax Treatment
When an individual sel s a personal residence, the excess of the sales price over the original cost
plus improvements is a capital gain and is subject to tax. The individual is able to deduct any
costs of the sale (such as commissions and advertising), and may be required to include gain that
was deferred from previous home sales.
Gain up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns is
excluded if the taxpayer meets a use test (has lived in the house for at least two years out of the
last five years) and an ownership test (has owned the house, also for two years out of the last
five). The exclusion can be used every two years.3

1 For average and median house prices, see FRED Economic Data, Average Prices of Houses Sold for the United
States, https://fred.stlouisfed.org/series/ASPUS and Median Sales Price of Houses Sold for the United States,
https://fred.stlouisfed.org/series/MSPUS.
2 See Bureau of Economic Analysis, National Income and Product Accounts, T able 1.1.4, https://apps.bea.gov/iTable/
iT able.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey.
3 Some exceptions to these rules exist. If taxpayers have not lived in the primary residence for a total of two years out
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To minimize the tax, assuming the individual is subject to it, he or she must keep records of any
improvements during the entire time the home is owned and also, to comply with the law,
appropriately distinguish between expenditures that are repairs, which do not reduce gain, and
those that are improvements, which do reduce gain.
For homes that were acquired before the 1997 change in tax law, there may also be deferred gain
from previously owned residences. Under pre-1997 tax law, a taxpayer could defer the gain on a
home sale if another residence was purchased. If the new residence cost as much or more than the
old residence sold for, the tax on the entire gain was deferred. If the new residence cost less than
the sale price of the old residence, gains tax was due on the difference between the value of the
old and new residence (if less than the gain) and tax on the remainder was deferred. The
additional gain from previously owned residences makes it more likely that total gains wil
exceed the cap; had the 1997 law been in place for many years, much or al of the prior gain
would have been excluded.
Capital gains on homes (and assets general y) held at least a year are taxed at lower rates that are
linked to the permanent rate schedule (and not the temporary one effective for 2018-2025): 0%
for taxpayers in the 10% and 15% marginal income tax brackets; 15% for taxpayers in marginal
income tax brackets above 15%, but below the top rate; and 20% for higher-income taxpayers.
For 2022, the 15% rate begins applying at an adjusted gross income level of $83,350 for joint
returns ($41,675 for single returns) and the 20% rate begins applying at $517,200 for joint returns
($450,750 for single returns). An additional 3.8% net investment income tax applies to taxpayers
with incomes over $250,000 for married couples and $200,000 for singles. Neither the capital
gains tax nor the net investment income tax applies to excluded gains.
A special relief provision for military families and the Foreign Service al ows them to expand the
five-year period for the ownership and use tests to up to 10 years while on qualified official duty.
Another provision that may influence a taxpayer’s decision about sel ing a residence is a long-
standing provision that al ows the gain to be excluded entirely if the taxpayer does not sel the
home and leaves it as part of his or her estate. If an individual keeps his or her house until death
and leaves it to heirs, no tax on gain accumulated would be due, because the heir would be able to
deduct the fair market value at time of death from sales price. Tax may be due if the heirs do not
sel the home immediately after inheriting the property if the property increases in value. This
rule is cal ed a step-up in basis.
Development of the Current Rules
The gain realized upon the sale of a personal residence was taxed as capital gain until the passage
of the Revenue Act of 1951 (P.L. 82-183). At that time, Congress passed a rollover provision that
al owed for the deferral of capital gains tax if the proceeds of the sale were used to buy another

of the last five, they are eligible for a partial exclusion cap if the real estate was sold because of a change in
employment, health, or unforeseen circumstances. T he taxpayer can receive a portion of the exclusion cap, based on the
portion of the two-year period they resided in the home. For example, a single taxpayer who lived in the house for one
year and qualified for an exception would have a $125,000 cap. For people living in a nursing home, the ownership and
use test is lowered to one out of five years before entering the facility. And time spent in the nursing home still counts
toward ownership time and use of the residence. For example, if a taxpayer lived in a house for a year, and then spent
the next five years in a nursing home before selling the home, the full $250,000 exclusion would be available.
No rationale is stated in the legislative history of this long-standing provision, although proposals have been made to
alter it. One justification is to address the difficulty with establishing basis for assets held for a long time.
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residence of equal or greater value within a year before or after the sale of the old residence.
Congress stated that the rollover provision was in response to transactions that were
necessitated by such facts as an increase in the size of the family or a change in the place
of the taxpayer’s employment. In these situations the transaction partakes of the nature of
an involuntary conversion. Cases of this type are particularly numerous in periods of rapid
change such as mobilization or reconversion.4
At that time, the economy had grown as a result of industrialization and residential moves were
more frequent due to business transfers and other employment related changes. Congress also
recognized that capital gains from home sales were, in part, a result of general inflation. During
the congressional debate, the rollover provision was justified on the grounds that homeowners
were changing homes, not to make a profit as investors, but rather in response to employment or
family size changes.
The first exclusion from taxation for capital gains on the sale of a primary residence was enacted
by the Revenue Act of 1964 (P.L. 88-272). The provision was available only for the elderly (aged
65 and older) and applied to residences sold after 1963. It was available on a one-time basis only,
and was at the same level for both single and married individuals. To qualify, the house had to be
occupied for five of the previous eight years. The exclusion of gain was limited to the amount
attributable to the first $20,000 of sales price. Above that level, a ratio was used to determine the
gain subject to taxation, such that the amount of the exclusion depended on the relationship of
sales price to basis, as wel as the relationship between $20,000 and sales price. For example, if
the sales price were $40,000, one-half of the gain ($20,000/$40,000) could be excluded.
However, the actual amount excluded would be less than $20,000, unless the house original y
cost $20,000. For example, if the basis in the house was $10,000, the gain on the $40,000 sale
would be $30,000. Of that $30,000, one half, or $15,000, would be excluded because $20,000
was half the sales price.
The reason given for the exclusion was to reduce the burden on elderly taxpayers who would
have to tie up al of their investment in a new home to avoid paying capital gains tax. The dollar
restriction was due to a focus on the average and smal er home, thus suggesting a distributional
motive.5
The amount of capital gains excludable from taxation for older taxpayers was increased three
times in response to higher housing prices. The three increases were enacted by The Tax Reform
Act of 1976 (P.L. 94-455), the Revenue Act of 1978 (P.L. 95-600), the Economic Recovery Tax
Act of 1981 (P.L. 97-34) and final y, the Taxpayer Relief Act of 1997 (P.L. 105-34). The limit for
elderly homeowners rose to $35,000 in 1976, $100,000 in 1978, and $125,000 in 1981. The 1978
provision also liberalized the benefit by simply al owing an exclusion rather than a proportional
share that depended on basis and lowered the age limit to 55. (There was consideration of
eliminating the age requirement altogether.) The 1978 change also reduced the holding period
requirement to three out of the previous eight years.
In each case of capital gains relief, Congress cited the rising sale prices of homes as the source of
large amounts of taxable capital gains on residences and the reason for adjusting the amount of
capital gains that could be excluded from taxation.

4 U.S. Congress, Senate Committee on Finance, The Revenue Act of 1951: Report to Accompany H.R. 4473, 82nd
Cong., 1st sess., S.Prt. 82-781 (Washington: GPO, 1951), p. 34.
5 U.S. Congress, House Ways and Means Committee, Report to Accompany H.R. 8363, 88th Cong., 1st sess., H. Prt. 88-
749 (Washington: GPO, 1963).
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When the rollover provisions and one-time exclusion for the elderly were replaced by the current
exclusion (in the Taxpayer Relief Act of 1997, P.L. 105-34), a major reason given was to reduce
the recordkeeping burden and to eliminate the need for referring to records and making
judgements about what expenditures are improvements.
Other reasons cited for changing the tax law were to limit the distortions in behavior arising from
the rollover treatment and from those elderly who had exceeded the exclusion limit or had already
used it. Because the full deferral of tax required the purchase of a new residence of equal or
greater value, the law may have encouraged taxpayers to purchase more expensive homes than
they otherwise would have. The pre-1997 rules also discouraged some elderly taxpayers from
sel ing their homes to avoid possible tax consequences. As a result, elderly taxpayers who had
already used their one-time exclusion and those who might have realized a gain in excess of
$125,000 may have retained their homes even though it was desirable for them to move.
It was also clear from statistical data that between rollovers, exclusions, step-up in basis (which
al owed capital gains to be avoided if the home were held until death and left to heirs), and under-
reporting, very little capital gains on owner-occupied housing were taxed. Thus, little revenue
was gained from a set of provisions that, nevertheless, caused distortions in behavior and
complicated compliance. These observations supported a simple elimination of the capital gains
tax on principal residences.
In 1997, Congress imposed what was characterized as a “relatively high” ceiling on the amount of
excluded gain, $500,000 for married couples. In a departure from the historic treatment of
lifetime exclusions, however, the exclusion was only half as large for single taxpayers as for
married couples—$250,000. The previous treatment had cut the exclusion in half for married
couples filing separately but not for single taxpayers, an important difference given that most
married individuals who do not divorce are eventual y widowed. Unlike the lifetime exclusion,
however, the exclusion could be taken in each period. In contrast to many other dollar limits in
the tax code, the amount of the exclusion was not indexed, so that it, like the previous exclusion,
might need to be periodical y revisited.
Two bil s in the 109th Congress addressed this provision. H.R. 2127, introduced by Representative
Filner, would have al owed taxpayers over the age of 50 to exclude an amount that is double the
current cap, but it was available only once in their lifetime. H.R. 2757, introduced by
Representative Andrews, would have indexed the exclusion. Other legislation (H.R. 3803 by
Representative McCarthy and S. 4075 by Senator Schumer) was introduced to change the amount
of the exclusion for surviving spouses to that of a married couple.
In the 110th Congress, S. 138 was introduced to al ow a surviving spouse to exclude up to
$500,000 of gain from the sale or exchange of a principal residence owned jointly with a
deceased spouse if the sale or exchange occurs within two years of the death of the spouse. That
provision was also included in H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007,
which was signed into law as P.L. 110-142 on December 20, 2007. Capital gains tax rates were
also changed in 1997. Before that time, capital gains were taxed at ordinary rates with a 28% cap,
leading to two rates of 15% (for the ordinary 15% bracket) and 28% for al other brackets. The
1997 legislation reduced those rates to 10% and 20%, respectively. In 2003, rates were reduced to
15% for 2003-2008 for those in the higher brackets and to 5% in 2003-2007 and 0% in 2008 for
taxpayers in the 15% bracket or lower. These rates were extended and in 2012 made permanent,
with a rate of 20% for the top bracket, leading to the current rates of 0%, 15%, and 20%. Health
reform legislation in 2010 provided for a tax of 3.8% on high-income taxpayers on various forms
of passive income, including capital gains. The exclusion also applies to the 3.8% tax.
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Effects of the Exclusion and Cap
The revenue cost of the exclusion is estimated at $40.3 bil ion for FY2022.6 The initial estimate
for this provision was $5.6 bil ion in FY1998, although the estimate was more than doubled to
$12.9 bil ion for FY2000 (which may have reflected better data availability).7 These estimates
were smal er than the amounts estimated for the previous provisions that al owed unlimited
deferral of taxes with a replacement home ($8.6 bil ion for FY1997) and the more limited
exclusion of gains for those over the age of 55 ($4.9 bil ion for FY1997).
A study examining the provision using 2007 data indicated that 0.57% of home transactions were
subject to the $500,000 and $250,000 ceilings. An additional 1.17% had taxable gain due to sales
that did not meet the holding period requirements. Thus, almost al taxpayers owed no capital
gains tax on the sale of principle residences.8 The share paying tax due to the ceilings represented
a rise from the time of enactment, when a much smal er number of transactions was expected to
be subject to the exclusion. Data from 1999 indicated that only 0.04% of taxpayers were
affected.9 The rise in the share reflected the 58% increase in the average and median price of
houses between 1999 and 2007.
Data are not available to project the number of transactions affected currently, but the share
should rise significantly, as average house prices have risen by 67% for the median sale and 50%
for the average since 2007. Current data on sales prices of existing homes indicate that 29% of
home sale prices in 2021 were at $500,000 or more and 43% were at prices of $250,000 to
$500,000.10 Because about a third of sales involved single individuals, assuming they were evenly
distributed in the $250,000 to $500,000 class, 43% of taxpayers had sale prices that could
potential y expose them to capital gains taxes (as compared to 3% at the time the provision was
enacted). The fraction subject to the tax would depend on basis. In the 2007 data, basis was
around 50% of sales price. Although there is no way to estimate the share subject to tax, the data
for 2021 indicate that 13% of sales prices were above $750,000 and 7% were above $1 mil ion.
Significant portions of these taxpayers were likely to pay taxes because of the limit, as wel as
some portion in the 30% above the $250,000 range but below the $750,000 level. Taxpayers in
these categories most likely to be subject to tax are those who have owned their homes for a long
time and have a low basis.
The share of gains subject to tax because of the limit is estimated at 9% of the excluded tax for
2007. The gain due to nonqualifying sales is estimated at 1.3% of the excluded tax. The current
share of the gain subject to tax because of the limits would be larger currently as wel given the

6 Joint Committee on T axation, Estimates Of Federal Tax Expenditures For Fiscal Years 2020 -2024, JCS-23-20,
November 5, 2020, https://www.jct.gov/publications/2020/jcx-23-20/.
7 Joint Committee on T axation, Estimates Of Federal Tax Expenditures For Fiscal Years 1998 -2002, JCS-22-97,
December 15, 1997, https://www.jct.gov/publications/1997/jcs-22-97/ and Estim ates Of Federal Tax Expenditures For
Fiscal Years 2000-2004, JCS-13-99, December 22, 1999, https://www.jct.gov/publications/1999/jcs-13-99/.
8 See Gerald Auten and Jane G. Gravelle, “T he Exclusion of Capital Gains on the Sale of Principal Residences: Policy
Options,” National T ax Association Proceedings, 102 Annual Conference on T axation, 2009, https://ntanet.org/wp-
content/uploads/proceedings/2009/012-auten-the-exclusion-capital-2009-nta-proceedings.pdf. Because of the way
taxpayers reported their transactions, it was not possible to determine precisely which taxpayers reached the maximum
exclusion.
9 T he Auten and Gravelle study indicated that 2,000 taxpayers were subject to the limit in 1999. In that year, home
sales were 5.21 million. See T itleNews Online Archive, “ 2001 A New Record, December Existin g-Home Sales
Strong?” NAR Reports, January 28, 2002, https://www.alta.org/news/news.cfm?20020128-2001-A-New-Record-
December-Existing-Home-Sales-Strong—NAR-Reports.
10 National Association of Realtors, “Summary of November 2021 Existing Home Sales Statistics,” December 12,
2021, https://cdn.nar.realtor/sites/default/files/documents/ehs-11-2021-summary-2021-12-22.pdf.
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increase in housing prices and the top capital gains tax rates. These ratios would be a little higher,
estimated currently at 11.7% and 1.8% due to the higher taxes in effect. These amounts would be
higher with the growth in home prices, as gains increase but exemptions remain constant. If these
same ratios held today, the revenue gain from the ceiling would be $3.6 bil ion, but adjusted for
the higher top tax rate it would be $4.7 bil ion. The tax savings would be even larger, however,
because the increase in prices increases gains while holding the ceiling fixed, and gains would
increase proportional y more. If the estimate is further adjusted for the 50% increase in average
home prices, just for the $500,000 and above categories, the amount would increase by a third, to
$6.3 bil ion. Further increases would also occur with other categories such as the $250,000 to
$500,000 class (where adjustments cannot easily be made and some taxpayers would not have
appeared in the 2007 data) and the $100,000 to $250,000 class that would not have appeared in
the 2007 data due to the limit in 2007.
Is Relief From the Capital Gains Tax on Residences
Justified?
Economists have often been critical of preferential treatment of certain types of activities, because
that preferential treatment distorts behavior and causes a misal ocation of capital. Tax preferences
also narrow the tax base and require higher marginal tax rates for a given revenue target; these
higher tax rates in turn magnify other distortions. Tax preferences also can be inequitable,
favoring those who engage in tax-preferred activities. (Tax preferences are also sometimes
criticized because they favor higher-income individuals; the appropriateness of such criticisms
depends on one’s view of how taxes should be distributed and whether such preferences are offset
by a more graduated rate structure.)
It is also true that the favorable treatment for owner-occupied housing may divert investment
from business investment. Absent a market failure, this misal ocation reduces the efficiency of the
economy. Favorable capital gains treatment for housing is not the only tax benefit it receives, or
even the most important in economic terms. The implicit income from housing is not subject to
tax, yet costs such as mortgage interest and property taxes are al owed as deductions, at least for
those who itemize. The benefits of itemized deductions for mortgage interest and property taxes
are currently limited under temporary changes made in 2017.11 Those temporary changes also
significantly reduced the effective tax rates for business investment as wel . In general, the
current effective tax rate on the return to owner-occupied housing is similar to the rate on
business investment, although it wil be favored compared to business under permanent rules.12
Housing is often claimed to provide other benefits that justify favorable treatment, although such
benefits have not general y been measured.13
It is not clear whether the prospect of future capital gains relief plays an important role in
inducing additional investment in housing. Unlike mortgage interest deductions, future capital

11 T hree provisions in the 2017 legislation (P.L. 115-97) reduced the benefit of itemized deductions: (1) an increase in
the standard deduction that made itemizing less beneficial, (2) a cap on state and local taxes of $10,000, and (3) a
reduction in the mortgage interest deduction allowed from that on $1 million of indebtedness to $ 500,000. These
provisions apply through 2025. T here is a permanent limit on interest deduction for indebtedness up to $1 million,
which was enacted in 1987.
12 See T able 9 in CRS Report RL34229, Corporate Tax Reform: Issues for Congress, by Jane G. Gravelle.
13 See CRS In Focus IF11305, Why Subsidize Homeownership? A Review of the Rationales, by Mark P. Keightley for a
discussion.
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gains relief provides no immediate cash flow benefit, and may be heavily discounted due to the
delay and uncertainty of the benefit.
In addition, there are some good reasons to provide some relief for capital gains on owner-
occupied houses and to restrict other owner-occupied housing tax benefits if a reduction in the
preferential treatment of owner-occupied housing is desired. Perhaps the most important of these
justifications for relief is to reduce the barriers to labor mobility, contributing to economic
efficiency. Other reasons include reduction in other inefficiencies that distort housing costs; more
equitable treatment among homeowners in different circumstances; and reduction of compliance
burdens. Empirical evidence suggests that significant distortions are induced by the gains tax
once an individual has a home and wishes to move.14
In contrast, the exclusion can contribute to compliance problems, by al owing a potential for tax
sheltering. These tax sheltering problems are discussed below in the “Contribution of Provision to
Tax Sheltering and Avoidance” section.
The possible forms of capital gains revisions are closely tied to these rationales and issues.
Therefore, following the general discussion of the rationales, this report also considers the
implications of the particular forms of these potential changes.
Labor Mobility
One of the important reasons for having some type of relief is to minimize the barriers to labor
mobility. To have an efficient market economy that can respond to changes in tastes and
technology, it is imperative to have as few barriers to labor mobility as possible. This
consideration was reflected in the rationale for the rollover provision enacted in 1951. Americans ’
taste and preference for owning their own homes inevitably creates barriers to a wil ingness to
relocate, barriers that cannot be avoided. Imposing capital gains tax at sale adds to that barrier.
The rollover provision, as it existed in prior law, provided some relief but stil left some barriers
to mobility in place. One problem arose because of regional differences in housing prices, which
stil exist. If the individual was moving to an area that general y has lower prices (e.g., from
California to Arizona), it might be sensible to buy a house that was similar in quality but cost less
because of lower overal area prices (which might also have included a lower salary). This shift
would result in a capital gain, and the individual then might have been discouraged from making
the move or induced to purchase a larger house than otherwise desirable. Circumstances where it
might have been more desirable to rent rather than to purchase a new home when relocating may
also have existed (e.g., when the family is moving because of economic hardship or the new
location is expected to be the place of employment for only a few years). The rollover provision
would not have reduced the capital gains barrier in that case. Thus, the rollover provision was
imperfect in its elimination of labor mobility barriers.
The capped exclusion eliminates al barriers, as long as the cap is not exceeded, and reduces the
cost of labor mobility. Unless the cap is increased explicitly or indexed to housing prices,
however, an increasing share of individuals wil be affected by the ceiling over time and barriers
to labor mobility wil grow.

14 Leonard E. Burman, Sally Wallace, and David Weiner, “How Capital Gains T axes Distort Homeowners’ Decisions,”
Proceedings of the 89th Annual Conference on Taxation of the National Tax Association (Washington, DC: National
T ax Association, 1997), pp. 382-390.
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Other Distortions
Aside from the labor mobility problem, capital gains taxes on owner-occupied housing can cause
other distortions. Capital gains taxes on assets in general cause a lock-in effect (i.e., discourage
changes in portfolio al ocations by replacing old assets with new assets). That the lock-in effect
for homes in particular may impose greater costs. Financial assets are more likely to be close
substitutes, so the lock-in effect is probably not very costly. (However, it is also possible to swap
real estate investments without paying a capital gains tax via a 1031 exchange.) Some might
argue that people should be encouraged to hold on to investments in the stock market for a long
period of time, in order to average out the ups and downs of the market, and the lock-in effect
may actual y be beneficial in some cases.
Different types of housing, however, may be less substitutable for each other; the difference
between the house to which an owner is “locked-in” and the home he desires may be more
important than for various alternative financial assets. And with no relief provisions, capital gains
taxes discourage moving, whether to a larger house (e.g., to accommodate a larger family) or a
smal er one (when children have grown and left the home or to simplify maintenance during
retirement). As noted above, a rollover treatment can cause people to buy too much housing or
continue to own when renting might be optimal. The once-in-a-lifetime exclusion that aided the
elderly was aimed at older individuals who might wish to sel their houses to move into smal er
and more easily maintained houses, to move to a rental status, or to “cash out” the value of the
house for other purposes. If the exclusion cap does not come into play, these distortions do not
exist, but, as noted above, if the cap does not rise with housing prices it wil become increasingly
binding.
The current provision permitting a capped exclusion every two years actual y creates, for those
affected, the opposite distortion. It favors higher-income individuals who move more frequently.
For instance, an individual who has a capital gain at the limit can move, take advantage of the
gains exclusion, and then, within, two years take advantage of it again, while the individual who
sel s only once, but has an equal gain would have to pay tax. Suppose, for example, that one
taxpayer (a single individual) realizes a capital gain of $200,000 on the sale of a home, purchases
another home, and then sel s that second home two years later, earning an additional $200,000 in
capital gains. The taxpayer would be able to exclude $400,000. If a similar taxpayer experiences a
single gain of $400,000 in the same time period, he or she may exclude only $250,000. Of course,
any tax benefits from moving more often may have little effect on behavior, given the
transactions costs and general burdens of changing residences.
Equity Issues
The caps on both the prior one-time exclusion and the current exclusion were enacted to impose
gains taxes on higher-income individuals with large capital gains, and therefore the caps are
presumed to have a vertical equity objective because they limit the benefit for high-income
taxpayers.
The cap, however, produces some horizontal inequities. First, the limited exclusion combined
with the step-up in basis at death causes elderly taxpayers who had to move from their homes due
to il health to pay taxes not assessed on their healthier counterparts who remain in their homes
until their death and leave the houses to their heirs with no capital gains tax.
The cap itself also produces some inequities among individuals who sel their homes and who are
affected by the cap. These inequities are of three types: (1) between those who move frequently
and those who do not; (2) between people living in different regions of the country; and (3)
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between married couples in which both spouses survive until the point they wish to sel and those
in which only one spouse survives.
In the first case, people who buy and sel frequently (and are thus less likely to accrue a large gain
in a particular sale) are less likely to be affected by the tax. For example, a married couple who
sel s every five years and gets a $150,000 gain on each sale would not pay a gains tax. If a similar
couple buys a house and sel s after 20 years with the same accumulated gain (four times $150,000
or $600,000), they wil pay a tax.
Taxpayers living in states and locations where the cost of living, including housing prices, tends
to be high, are more likely to be affected by the cap even in cases where their real incomes and
standard of living are the same as those who are not affected. For example, taxpayers in
California and Massachusetts are more likely to be affected than taxpayers in Mississippi and
Oklahoma.
Final y, the tax is more likely to fal on elderly taxpayers who have lost a spouse than married
couples who remain alive at the time they wish to sel their house. Although the tax laws al ow
the gain for the spouse who is deceased to be excluded (half the gain at that time), further capital
gain exclusions are limited by the lower ceiling that applies to singles.15 For example, suppose the
gain on a house is $400,000. In the case of a married couple who sel s, the entire gain wil be
excluded. In the case of a surviving spouse, the exclusion wil be $250,000 plus half of any gain
that accrued during the deceased spouse’s life; if that gain is less than $150,000 some tax wil be
due. Because most women marry men who are older than they are, and because women live
longer than men, a significant number of widows are likely to live in the house after the spouse
has died.
Recordkeeping
Recordkeeping required to deal with the capital gains tax on residences is complex. To comply
with tax regulations, taxpayers have had to keep detailed records of the financial expenditures
associated with their home ownership. The taxpayer needs to record the original cost of the
residence, any costs added at the time of purchase, and any capital improvements. In the latter
case, taxpayers also have had to differentiate between those expenditures that affected the basis of
the property and those that were merely for maintenance or repairs.16 In many instances, these

15 If a surviving spouse and the decedent owned the home jointly, the basis in the home changes after the death of the
decedent. T he new basis for the half interest that the decedent owned will be one-half of the fair market value on the
date of death (or alternate valuation date). For example, suppose a couple jointly owned a home that had an adjusted
basis of $100,000 on the date of one spouse’s death. T he fair market value on that date was $200,000. T he new basis in
the home is $150,000 ($50,000 for one-half of the adjusted basis plus $100,000 for one-half of the fair market value).
16 Calculating capital gains requires a measure of basis. A taxpayer’s basis in real estate is cost (or fair market value if
acquired by inheritance). T he cost of property is the amount paid for it in cash, debt obligations, other property, or
services, which can include the purchase price and certain settlement or closing costs. When calculating the gain or loss
on the sale of a residence, the basis is adjusted for changes made since the acquisition of the property. Increases to basis
include the cost of capital improvements, such as air conditioning or a new roof; special assessments for local
improvements; and any other additions that have a useful life of more than one year. Examples of decreases to basis
include any capital gain that was postponed from the sale of a previous home before May 7, 1997; deductible casualty
losses or insurance payments received for casualty losses; payments received for granting an easement or ri ght-of-way;
depreciation allowed if the home was used for business or rental purposes; a first -time homebuyer credit (allowed to
certain first -time buyers of a home in the District of Columbia); and energy conservation subsidy excluded from gross
income because it was received to buy or install any energy conservation measure.
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records have to be kept for decades. Congress has addressed this issue, stating in the reasons for
the 1997 increase in the exclusion that
calculating capital gain from the sale of a principal residence was among the most complex
tasks faced by a typical taxpayer.... [A]s a result of the rollover provisions and the $125,000
one-time exclusion under prior law, detailed records of transactions and expenditures on
home improvements had to be kept, in most cases, for many decades.17
The 1997 tax law simplified income tax administration and record keeping by providing a
“relatively high threshold, few taxpayers wil have to refer to records in determining income tax
consequences of transactions related to their house.”18
The capital gains exclusion, however, was not indexed for inflation or for housing price c hanges.
The average of existing home sales has increased by 151% since 1997 and the median price has
increased even more. As noted in the “Introduction”, if the $500,000 ($250,000) values had been
increased to reflect the average housing price, they would be approximately $1,300,000
($650,000); if they had been increased to reflect the median housing price by 2021, they would be
$1,400,000 ($700,000).19 If they had been increased to reflect the general price rise in the
economy (the GDP deflator), they would be $800,000 ($400,000).20 In addition, gain on houses
increased proportional y more. For example, if the basis (the original cost) of the house in 1997
were half the market value purchase price, a 150% increase in value would mean a 300% increase
in the gain. This appreciation means that many more taxpayers would be subject to the ceiling.
Without an indexing procedure, some of the potential recordkeeping benefits from the 1997
revision have been lost. It would be unwise for many taxpayers to abandon recordkeeping given
that the exclusion is covering fewer and fewer sales over time and there is no commitment from
the government to index the provision, so that the simplification from less recordkeeping is likely
to be diminished.
Contribution of Provision to Tax Sheltering and Avoidance
The presence of a special exclusion contributes to the possibility of using the tax benefit to avoid
capital gains taxes in unintended ways. This section discusses several ways this might occur.
Converting Rental Property to Owner-Occupied Property
Capital gains avoidance can occur by converting rental property to owner-occupied property.
After this conversion, the property can be sold and the capital gains excluded up to the al owable
amount, as long as the property has been owned and used as a principal residence for at least two
years during the five-year period ending on the date of the sale of the residence. For example,
consider a married couple who have a primary residence and a rental property and both properties
have substantial y appreciated in value. The couple can sel the primary residence and claim a
capital gain exclusion of up to $500,000 on that residence. The couple can then move into the

17 U.S. Congress, Joint Committee on T axation, General Explanation of Tax Legislation Enacted in 1997 , 105th Cong.,
1st sess. (Washington: GPO, 1997), pp. 54-55.
18 U.S. Congress, Joint Committee on T axation, General Explanation of Tax Legislation Enacted in 1997 , 105th Cong.,
1st sess. (Washington: GPO, 1997), pp. 54-55.
19 For average and median house prices, see FRED Economic Data, Average Prices of Houses Sold for the United
States, https://fred.stlouisfed.org/series/ASPUS and Median Sales Price of Houses Sold for the United States,
https://fred.stlouisfed.org/series/MSPUS.
20 See Bureau of Economic Analysis, National Income and Product Accounts, T able 1.1.4, https://apps.bea.gov/iTable/
iT able.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey.
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rental property and use that as the primary residence. After two years the taxpayers could then sel
the property and realize a gain of which up to $500,000 can be excluded under the law. It makes
no difference that most of the appreciation on the second property was realized when it was a
rental unit. Current tax law, however, does require that any depreciation on the rental property be
recaptured and taxed.21
An example of the depreciation recapture can be seen in the following example. A married couple
sel s their primary residence which had an adjusted basis (purchase price plus capital
improvements) of $100,000 for $200,000. In prior years, the property had been a rental property
and the couple had claimed $50,000 in depreciation deductions on the home. The taxable gain for
the sale would be $100,000, which is the sales price minus the adjusted basis. Of that gain,
$50,000 is tax-free and the $50,000 taken as depreciation deductions in the past would be subject
to a 25% capital gains tax.
“Like-Kind” Property Exchanges
Taxpayers can avoid paying tax on the gain from the sale of their real estate property by
participating in a “like-kind” property exchange. Under section 1031 of the Internal Revenue
Code, like-property exchanges offer business owners or investors a way to trade their property for
something of similar value and type without reporting a profit and, thereby, defer paying taxes on
the gain. In the case of residential property, this exchange can be combined with the exclusion of
capital gains to al ow taxpayers to avoid capital gains tax on some of the deferred gain. Some
gain on the original investment property would be taxed as recaptured depreciation, and some
may be taxed if the total remaining gain exceeds the cap. For example, a taxpayer who owns a
rental property can participate in a like-kind exchange for another residential property, which then
becomes the taxpayer’s primary residence. The taxpayer must meet the ownership and use tests
for a minimum of five years before the taxpayer can then sel the property and exclude capital
gains up to the al owable amount. Essential y, the taxpayer wil have sold real estate and avoided
capital gains taxation on some, and perhaps most, of the capital gains earned on both properties.
Prior to October 2004 when the American Jobs Creation Act of 2004 (P.L. 108-357) was enacted,
there was no minimum holding period for properties acquired through like-kind exchanges. The
exclusion of gain on the sale of a principal residence applied after two years, when the ownership
and use tests for the provision would have been met. The 2004 law requires the taxpayer to hold
the exchanged property for a full five years, as opposed to two, before the residence can qualify
as a principal residence. This change reduced, but did not eliminate, the attractiveness of
combining like-kind exchanges with the principal residence exclusion.22
Sharing Capital Gains
If taxpayers expect huge gains from owning, then sel ing a house—more than can be excluded
from tax under the new rule—they could divide ownership of the house to maximize the amount
of capital gain that could be excluded. If, for example, a married couple owns their residence
together with an adult son and he meets the ownership and use tests for one-third of the property,
the son may sel his share for a $250,000 gain without incurring a tax. His parents could
simultaneously sel their share for $500,000 without tax, sheltering as much as $750,000 in
capital gains. Note that this avoidance technique arises not from the exclusion, but from the

21 T he recapture rule, enacted by the T axpayer Relief Act of 1997, applies to depreciation claimed after May 6, 1997.
Any depreciation taken before that date is “ forgiven” and not recaptured.
22 More information available in CRS Report RS22113, The Sale of a Principal Residence Acquired Through a Like-
Kind Exchange, by Gregg A. Esenwein (out of print but available to congressional staff from the author).
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presence of a cap. This approach to tax avoidance involves some constraints and risks: the child
must live in the residence, and the property could be subject to attachment for the child’s debts.
Including Investment Property with the Home
This avoidance technique might be termed the “land with a smal house” strategy. A taxpayer can
purchase a house with a significant amount of land as an investment, and then use the exclusion
for the residence to also exclude gain on the land. A taxpayer can also sel vacant land adjacent to
your home separately from the home itself, as long as the home is also sold either two years
before or two years after the sale of the vacant land. There are some restrictions on this exclusion
for land, one being that the land must not only be adjacent to the home but used as part of the
home (which would rule out farm land, timber land, and other uses but not simple speculation).
The Professional “Fixer-Upper”
An individual can buy a house that needs substantial renovation as a principal residence, fix it up,
live in it for two years, and then sel the home. This gain reflects untaxed labor income of the
individual, which is now excluded from tax. In fact, this approach can be used by professional
builders who would normal y be paid for their services.
Cottage and Home
An individual who has both a regular home and a vacation home can take measures to shift the
vacation home to principal residence status. Such an individual may effectively continue to live in
the original home in part, but after the required holding period can sel the vacation home, avoid
capital gains, and move back to the regular home as a permanent residence. Which home is
determined to be the principal residence is based on a facts and circumstances assessment,
including the length of time the taxpayer lives in each home, the location of employment and the
principal residences of family members, mailing addresses (on bil s and correspondence, tax
returns, drivers’ licenses, and car and voter registrations), the locations of banks used, and the
location of recreational associations and churches where the taxpayer has a membership. Thus, it
is not easy to establish the vacation home as the principal residence, though it may be feasible in
some cases and, of course, the Internal Revenue Service cannot audit every case of this type.
House Swapping
In this avoidance technique, wealthy individuals sel their homes back and forth periodical y to
qualify frequently for the capital gains tax exclusion. If they mutual y agree to this arrangement,
the transactions costs could be minimal (i.e., a lawyer to search the title and record the
transaction). They may not even live in the exchanged homes. Such an arrangement is il egal (a
sham transaction) but may be difficult to detect. This avoidance technique arises from the
existence of the cap.
Options for Change
Although numerous potential ways exist to deal with capital gains taxes on owner-occupied
housing, including retaining the current rules or returning to the pre-1997 rules, two areas where
changes might be considered are the ceilings on the exclusion and in rules relating to investment
property and tax sheltering.
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Options for addressing the ceilings could include eliminating the ceilings altogether, indexing the
ceilings either with respect to general inflation or housing prices, changing the relative ceilings
between single and joint returns, or changing the basic structure of the ceilings.
Eliminating the Ceilings
One policy option could be to remove the ceilings altogether. For some taxpayers, the exclusion
with ceilings enacted in 1997 increases their tax liability, because they might otherwise have used
the rollover provision and then held the asset until death.
One advantage of eliminating the ceilings would be the elimination of any remaining distortions
(such as incentives not to sel a house even if it would be desirable) and recordkeeping
requirements. This efficiency gain would reflect not only benefits to high-income individuals who
actual y pay the tax, but also the much larger group who, because of uncertainty, need to keep
records. As the discussion above on indexing indicates, by one index, houses have, on average,
increased in value by 160% in the 24 years since the existing ceilings were imposed.23 Suppose in
1997 a married couple had a home worth $300,000 with a $200,000 gain. A 160% increase would
have caused the new home value to rise to $780,000 for a $680,000 gain. The gain would have
more than tripled and would exceed the limit of $500,000.
Other circumstances could cause such a taxpayer to be over the limit. The percentage gain figure
cited above is averaged across the country. In several cities across the country, including some in
California, the average value of houses has increased more quickly. Another circumstance in
which the ceiling would be exceeded is if a spouse dies before most of the additional appreciation
occurs. In that case, the surviving spouse could be over the exclusion limit because the exclusion
would be limited to about $350,000 ($100,000 for half the appreciation that had already occurred
and the $250,000 limit for single individuals). Final y, while some individuals sel houses more
frequently, others live in them for a very long time. These examples il ustrate that individuals who
are living in houses that may currently have accrued gains or have values wel below the limit on
the capital gains exclusion would need to keep records given the uncertainty about how long the
house wil be owned, what the appreciation rate wil be, whether and when Congress might act to
change the ceiling, and whether a spouse might die.
Eliminating the ceilings would also eliminate the inequities that arise among homeowners. These
inequities tend to arise because of differences in housing prices across states and localities,
differences that lead to more or less frequent sales of houses, and differences among elderly
homeowners that arise from different health outcomes that require the sale of a house.
Eliminating the ceilings has some disadvantages. It would involve a revenue loss. In addition,
some people might see its expected favoritism of high-income individuals to be a disadvantage.
Any reduction in tax progressivity, however, would be minor. The revenue loss from eliminating
the ceilings is relatively minor in comparison to the revenue loss for the exclusion in general and
the taxes collected on other assets of high income individuals. As estimated above, the cost of
eliminating the ceiling is about $6 bil ion. This amount is smal relative to the capital gains taxes
paid by high-income individuals. For example, an estimate for the taxes paid on capital gains and
qualified dividends for individuals with $200,000 or more of income was $390 bil ion for 2021;
based on data from Internal Revenue Service Statistics, about $316 bil ion of that was on capital

23 FRED Economic Data, Average Prices of Houses Sold for the United States, https://fred.stlouisfed.org/series/
ASPUS.
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gains.24 It is also smal compared with total income taxes, with taxes paid by those with $200,000
or more in income estimated at $1,598 bil ion. Thus, while the taxes paid above the exclusion are
concentrated in higher-income families, they are smal compared with overal taxes on capital
gains or al taxes paid by high-income individuals.25
For example, in 1999,26 reported taxable capital gains on the sales of residences were in the range
of $3.7 bil ion to $4.9 bil ion.27 Assuming a 20% tax rate, the tax on this amount was less than $1
bil ion and much of this amount may be due not to the cap but to failing to qualify in other ways.
For that same year, the reported revenue loss from untaxed capital gains was estimated at $5.8
bil ion.28 Thus, the presence of the cap limited the amount of revenue loss from the exclusion of
capital gains by less than—perhaps much less than—17%.
Moreover, the data collected on tax returns filed in 1995 and 1996 (before the 1997 change)
indicate that the benefits did not solely or even largely accrue to high income individuals if
income is measured without including the gain itself.29 These data show large shifts in the
distribution between 1995 and 1996, but in both years from 20% to 25% of the tax that would
have been collected under the new law accrued to individuals with incomes below $20,000. In
1996, very little of the tax (less than 20%) would have been paid by those with incomes over
$100,000. The distribution of the tax that one might normal y think would accrue to high-income
individuals may reflect sales due to divorce, job loss, and il health. Indeed, wealthy individuals
may be more likely to have the resources to keep their houses through these types of changes.
As these data suggest, compared with other capital gains provisions, the cap on residential capital
gains has relatively smal revenue effects and plays a relatively smal role in the distribution of
the tax burden. Therefore, although revenue and distributional issues may be of concern, other
changes could easily be made that would accomplish those same goals.

24 T ax Policy Center, “Individual Income T ax on Long-T erm Capital Gains and Qualified Dividends,” T able T 21-0204.
https://www.taxpolicycenter.org/model-estimates/distribution-individual-income-tax-long-term-capital-gains-and-
qualified-67. Data on the division between qualified dividends and capital gains from Internal Revenue Service,
Statistics of Incom e, Individual Income T axes, 2019, T able 1.4, https://www.irs.gov/statistics/soi-tax-stats-individual-
statistical-tables-by-size-of-adjusted-gross-income.
25 Computed from T ax Policy Center, Baseline Distribution of Income and Federal T axes, T 21 -0087,
https://www.taxpolicycenter.org/model-estimates/baseline-distribution-income-and-federal-taxes-july-2021/t21-0087-
baseline; Average Effective T ax Rates–All T ax Units, T 21-0133, https://www.taxpolicycenter.org/model-estimates/
baseline-share-federal-taxes-july-2021/t21-0133-average-effective-federal-tax-rates, and Share of Federal T axes – All
T ax Units, T able T 21-0115, https://www.taxpolicycenter.org/model-estimates/baseline-share-federal-taxes-july-2021/
t21-0115-share-federal-taxes-all-tax-units.
26 U.S. Department of T reasury, Internal Revenue Service, Statistics of Income, Short T erm and Long T erm Capital
Gains by Asset T ype, T ax Year 1999, https://www.irs.gov/statistics/soi-tax-stats-sales-of-capital-assets-reported-on-
individual-tax-returns.
27 Inconsistencies in how the exclusion was actually reported on returns results in some uncertainty about the actual
size of the gain, but it should fall between these two values.
28 U.S. Congress, Joint Committee on T axation, Estimates of Federal Tax Expenditures for Fiscal Years 1999-2003,
committee print, 105th Cong., 2nd sess., December 14, 1998, JCS-7-98, p.18.
29 See Gerald Auten and Andrew Reschovsky, The New Exclusion for Capital Gains on Principal Residences, National
T ax Association, Working Paper, October 1998. A previous version of this paper was published in the Proceedings of
the 90th Annual Conference on Taxation of the National Tax Association (Washington, DC: National T ax Association,
1998), pp. 223-230.
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Indexing the Dollar Cap
Rather than eliminating the cap, another approach would be to adjust the ceiling to reflect recent
price changes and index it for future price changes. A commitment to indexing, rather than
intermittently changing the cap as has occurred with prior exclusions, would provide individuals
more assurances that they might not need to keep records. This change would cost less revenue.
Using the 2007 data, for example, doubling the exemptions would have cost about 60% of the
cost of eliminating them entirely, while increasing them by 180% (to reflect the change in
housing prices, would cost about 70%. This cost would rise over time.30
Which index would be appropriate depends on the objective of the cap. The change in housing
prices has far outstripped the change in the overal price level by any measure If the objective of
the cap is to maintain a fixed inclusion to exclusion ratio, a house price index would be
appropriate. If the objective is to fix the cap in real terms, an index to a general price rise would
be appropriate.
The Single Versus Joint Exclusion
Another issue is whether the single exclusion should remain at a level that is half the joint
exclusion. In making the cap half as large for singles (or twice as large for married couples), the
provision departed from historical practices for the over-aged-55 exclusion. The 1997 change
doubled the existing $125,000 exclusion for singles, although that exclusion had not kept pace
with house price changes because it had not been changed since 1981. If the 1981 value had been
adjusted based on the average house price, it would be $680,000 in 2021.31 Thus, single
individuals who might have been eligible for the old age exclusion have lost ground compared
with some historical periods, while married couples have lost less. For an equivalent revenue
cost, this approach favors married individuals relative to single individuals, including widows and
widowers. (Both types of taxpayers could have been made worse off because there was no cap on
rollovers.)
Al owing the exclusion to be half as large for single taxpayers may have reflected, to some extent,
the tax planning problems faced by divorcing couples. If each taxpayer has the same ceiling, then
it is more advantageous to sel a house with a large gain after the divorce, when each individual
could have a full exclusion. This problem may have been less important for older individuals in
the past when divorce was less likely, but with the exclusion substituting for rollover treatment,
many more divorcing couples would be facing this problem. Higher-income individuals who
divorced and optimized their timing may be worse off under the post-1997 changes because they
were not eligible for an uncapped rollover or larger exclusion. However, the new rules are
beneficial for moderate income divorcing couples who wish to trade down. The change in relative
exclusions could have addressed the problem of unmarried couples who own houses together, an
issue that arose as part of the discussion of the “marriage penalty” in the income tax rate
structure. This latter phenomenon is probably not very numerical y important since, according to

30 T his estimate eliminated the tax on the $250,000 to $1 million classes of gains and increased the exemptions for the
$1 million and over classes.
31 Different values would be found if indexing where introduced from earlier levels. For example, using the Census
Bureau’s average new house index cited above, indexing from the 1964 level would have implied a current exclusion
that was slightly larger than the $250,000 one now allowed: $274,500. T he value had deteriorated by 1976, so that the
exclusion indexed from that point would be $200,000. Indexing from 1978, when a much larger exclusion was enacted
would produce a value of $439,000.
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Census data, unmarried couples were only 7% of households.32 Moreover, because they tend to be
younger, they are less likely to be homeowners.
Many of the single individuals sel ing homes, outside of divorcing couples, are likely to be
widows or widowers and the remainder are largely people who have never been married or who
have been divorced for some time. By reducing the exclusion ceiling for them, not only is the
benefit reduced relative to historical values, but complexity is introduced because more
individuals wil be subject to filing requirements and paying taxes. As noted above, 72% of
houses sold are estimated to have values over $250,000.
Although it eliminated the complexity for divorcing couples, the halving of the exclusion
especial y magnified compliance problems for surviving spouses. Although surviving spouses can
receive the benefit of the step-up in basis for the half of the house al ocated to the decedent, the
lower ceiling not only increases the frequency with which basis must be calculated (any time the
sales price is $250,000 or more) but also requires the measurement of the basis step-up. (Note:
Surviving spouses can get the full step up of the entire gain in community property states, such as
California.) These individuals may be more likely to have houses that fal into the taxable range
because they were married, perhaps for a long time. The lower limit in general adds to the risk
that even a couple with a modest house wil have to keep complex records because of the
possibility that one of them wil die before the house is sold.
One potential change would be to al ow surviving spouses to opt for the $500,000 exclusion as a
substitute for the step-up in basis if they are sel ing a house they lived in with their spouse, a
move that would simplify compliance for those whose housing values fal between $250,000 and
$500,000. H.R. 3803, introduced by Representative McCarthy in the 109th Congress, proposed
this al owance for certain surviving spouses.
In the 110th Congress, a similar proposal was introduced by Senator Schumer (S. 138) and
included in H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110-142), which
was signed into law on December 20, 2007. Specifical y, the new law al ows a surviving spouse
to exclude from gross income up to $500,000 of the gain from the sale or exchange of a principal
residence owned jointly with a deceased spouse if the sale or exchange occurs within two years of
the death of the spouse and other ownership and use requirements have been met. This provision
is limited to widows or widowers who sel their houses quickly.
Changing the Structure of the Exclusion
Another option is to change the structure of the exclusion in general. For example, there could be
a much larger lifetime exclusion, with each sale of a home using up part of the exclusion. A
lifetime exclusion would eliminate the incentive to turn over houses frequently and would
eliminate the penalty for holding on to one’s home for a long period of time. It would shift
benefits (even for the same revenue cost) from very wealthy people who sel houses frequently to
people who are less wealthy but have lived in their houses for a long time. It would, however, add
to administrative costs and to complexity for some people who would need to keep track of the
amount of the exclusion consumed.
A different approach would be that embodied in H.R. 2127 of the 109th Congress, which would
have al owed a one-time doubling of the exclusion for those over the age of 50.

32 Benjamin Gurrentz, “ Cohabiting Partners Older, More Racially Diverse, More Educated, Higher Earners,”
September 23, 2019, https://www.census.gov/library/stories/2019/09/unmarried-partners-more-diverse-than-20-years-
ago.html.
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Tax Sheltering of Investment Gains
A final issue is whether additional measures should be taken to prevent the use of the exclusion
from sheltering gains earned from investment property. Little to no evidence exists as to the
seriousness of this issue. According to revenue estimates, the restriction on like-kind exchanges
enacted in 2005 (requiring a five-year test) wil have a negligible revenue effect ($200 mil ion
over 10 years).33 The revenue loss from the converting of investment property into a residence is
likely larger.
Note that these tax sheltering problems are not unique to current law; they existed under prior law
as wel .
To deal with the investment and like-kind exchanges, the provision requiring longer residence
periods for like-kind exchanges could be expanded to property used as an investment. Another,
more direct approach, which might be used to raise revenue to finance cap expansions, would be
requiring the gain attributable to investment property to be separated out and taxed, as recaptured
depreciation is now taxed.
The conversion of investment property is probably the most important tax avoidance scheme.
Techniques such as buying a house with extensive land, establishing a vacation home as a
residence, or explicit house swapping can probably only be addressed through tax auditing. These
shelters would perhaps be made less attractive with longer holding periods, but longer holding
periods have other consequences (such as interfering with mobility). The effect of longer holding
periods would not be as onerous, however, because houses held for a short period of time are
likely to have little appreciation, especial y after deducting real estate commissions and other
sel ing costs. Partial exclusion could be al owed for cases where sales were due to employment
changes, and other factors. In addition, record keeping for a few years is not the burden that
would be the case if the house was owned for decades. House swapping would be reduced or
eliminated if the ceilings were increased or eliminated. It is very difficult to deal with the
professional “fixer-upper” problem, although, as in the case of other tax avoidance schemes,
longer holding period requirements would discourage such methods.
Conclusion
Capital gains on sales of taxpayers’ homes have been preferential y treated in the tax code for
decades. Current law al ows an exclusion from income taxation of up $500,000 in capital gains
for couples ($250,000 for singles). This preferential treatment is justified for several reasons.
Capital gains taxes on homes create barriers to labor mobility in the economy. Imposing capital
gains taxes on homes also creates significant compliance costs, requiring individuals to keep
records for decades and to make fine distinctions between improvements and repairs. Capital
gains taxes also tend to distort housing choices, discouraging individuals from sel ing their homes
because of changing family and health circumstances. The taxation of gains in excess of a cap
creates inequities between homeowners with different job circumstances, those living in different
parts of the country, and those with different health outcomes. Exclusions of gains on homes do,
however, contribute to tax avoidance schemes, especial y ones that al ow gains on investment
properties to escape tax.

33 U.S. Congress, Joint Committee on T axation, Estimated Budget Effects of the Conference Agreement for H.R 4520,
The “American Jobs Creation Act of 2004,” committee print, 108th Cong., 2nd sess., October 7, 2004, JCX-69-04.
Congressional Research Service

17

The Exclusion of Capital Gains for Owner-Occupied Housing

The exclusion from capital gains tax for owner-occupied housing currently exempts most
homeowners from the tax. Although the capital gains exclusion adds to the magnitude of
Congressional Research Service

18

The Exclusion of Capital Gains for Owner-Occupied Housing

homeowner preferences that may distort investment, there are reasons to exempt capital gains on
home sales from tax. The rise in housing prices juxtaposed with the fixed dollar cap for the
exclusion, however, has increased the share of homeowners subject to gains tax. The possibility
of capital gains tax in the future, arising from a cap that does not keep pace with housing prices,
substantial y reduces the number of taxpayers who could be freed from detailed record keeping.
The problems associated with the gains tax could be eliminated or mitigated with the elimination
of the cap or by indexing it to housing prices. The ceiling on the excluded gain, presumably
adopted for revenue and distributional reasons, is, however, of smal consequence compared with
other provisions (such as the general taxes and taxes on capital gains and dividends). A
complication of increasing or eliminating the ceiling, however, is the increased opportunity for
tax sheltering activities, which may suggest additional restrictions aimed at these activities.

Author Information

Jane G. Gravelle

Senior Specialist in Economic Policy

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