A Housing Boom Built on Folly


By Christopher Farrell It seems that everyone from Wall Street to Main Street to Capitol Hill is watching the biggest housing-market boom in history with awe and dread. Awe because trillions of dollars in new wealth has been created ($5 trillion since 1996) and the home-ownership rate has reached a record 69% of U.S. households. Dread because the boom is attracting so much speculative investing that a growing number of market watchers fear that a bust is inevitable and will end in economic catastrophe.

What accounts for the housing boom? Economists have cited a number of fundamental factors, including low interest rates, favorable demographics, and restrictions on development. But the unappreciated force that may have infected a strong housing market with home-buying mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act of 1997, signed by President Clinton.

Under a set of easily met limitations -- mainly that a home has been a primary residence for two out of the past five years -- a family can exempt the first $500,000 in profit on the sale of the home from capital-gains taxes. The comparable figure for a single filer is $250,000.

MONEY PIT. In sharp contrast, capital gains on stocks and bonds carry a 15% levy (the capital gains tax rate had been 20% until the tax law change of 2003.). The powerful lure of tax-free profit is one reason that home prices have risen at a nearly 7% annual rate, vs. about 4% for the stock market since 1997. Sell a home with a $500,000 profit and owe Uncle Sam nothing. But realize a $500,000 gain on Nextbreakthroughtechnology.com and the federal government takes 15%. That's the kind of math most people can figure out.

The issue goes way beyond tax fairness. A growing number of economists are deeply concerned that residential real estate is absorbing far too many economic resources. Money is pouring into concrete foundations rather than high-tech innovation. "Residential investment accounted for 35% of private investment in the past year, a level not seen since the early 1970s," notes Martin Barnes, the perceptive financial-market observer at Bank Credit Analyst.

"We're overinvesting in housing as a nation," says Mark Zandi, chief economist at economic-consulting firm Economy.com. And we have the 1997 tax-law change to thank, because that created much of the economic incentive to buy, flip, and buy again every two years.

UNBALANCED CODE. As much as possible, the tax code shouldn't bias investment decisions. As it is, the tax code is too heavily weighted in favor of housing. The Urban Institute calculates that the government provides about $147 billion in subsidies to homeowners, including the mortgage-interest deduction and capital gains exemption.

"The most politically successful segment in society are homeowners, builders, and realtors," says William Ahearn of the Washington, D.C.-based Tax Foundation. "The tax code is more slanted toward that group's favor than any other group."

Sure, calls by columnists for Congress to treat the home like any other investment typically flounder. The home-mortgage deduction is sacrosanct on Capital Hill, regardless of how many tax economists testify against it every year.

But the capital-gains law is different. It's only eight years old. Action ought to be taken before this bit of policy becomes as enmeshed as the tax break for mortgage interest. Besides, no policymaker is really happy with the froth in the real estate market.

STOCK SHIFT. Congress could level the investment playing field by treating capital gains on real estate, stocks, bonds, and other assets the same. I say levy the same 15% rate on all capital gains -- regardless of how they're realized.

Doing so would also reduce the incentive for speculative investment in real estate and remove some disincentive to investing in the stock market. My guess is that investors would shift more of their money into Corporate America, especially innovative companies that create the wealth of the future.

What's more, in an era of federal red ink as far as the eye can see, the revenue from home sales would help restore some fiscal sanity in Washington. People can be pretty smart with their money when given the chance. I say give them that chance.

THE NEXT BILL GATES. I realize that economists with a more supply-side perspective might prefer that capital gains be treated the same way that ones realized from housing are. But giving couples a break on the first $500,000 in profit -- and singles a break on the first $250,000 -- is hardly a laudable strategy in an era of spiraling budget deficits.

Owning a home may be synonymous with the American dream. But so is finding the next Microsoft (MSFT). Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online


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