California has it all – a vibrant and dynamic economy, stunning beaches, picturesque hiking trails, and world-class natural wonders such as Yosemite and Big Sur. The primary recurring drawbacks often associated with the state are its high taxes and housing prices. Yet, few have fully analyzed the strong correlation between these two significant challenges in our state. This article explores the direct relationship between higher taxes and lower housing supply, and discusses creative solutions that would stimulate more housing development in California.

A single-family home in Silicon Valley is becoming an increasingly scarce commodity with each passing year. In 2005, the earliest year for which statistics are available, there were 23,087 single-family homes sold in Santa Clara County. By 2023, this number has dwindled to just 8,496, marking a staggering 63% drop in sales volume. Notably, this decline occurred amidst a population growth of over 12% in the county. Despite the alarming nature of these figures, the trend of declining home supply for sale is expected to persist unless California or the federal government lowers the taxes due when selling your home.

What has led to such a momentous decline in the supply of single-family homes in California, and especially in Silicon Valley? The primary reason is the staggering amount of capital gains tax sellers will recognize upon selling. While there are other impediments contributing to the reluctance to sell, capital gains tax is generally the major deterrent for many sellers considering selling their homes at this time.

Although federal capital gains tax applies nationwide, Californians pay the most state tax by far. This is due to having the highest state capital gains rate in the nation at 13.3%, coupled with the most substantial appreciation of any region. Consequently, several of my long-term clients have faced taxes on millions of dollars’ worth of capital gains at a combined rate of 37.1% (13.3% for California, plus 23.8% for Federal). I have also witnessed many clients opt not to sell their homes after learning about the significant capital gains taxes they would incur upon sale.

DeLeon Realty CEO Michael Repka, an attorney with a strong background in taxation, including a graduate law degree from NYU School of Law, often discusses the benefit of elderly clients not selling until one of them passes away – a delicate but important discussion. This strategy allows their heirs to benefit from the stepped-up basis, thereby avoiding capital gains liability at both the federal and state tax levels.

The current shortage of supply is concerning, but the ongoing trend of declining supply could lead to illiquidity in the housing market and a freezing of supply unless changes are implemented to the tax code. The decreasing supply can be attributed to the increasingly small percentage of profits that are exempt from taxation. In 1997, President Clinton proposed abolishing the previous tax exemption for homeowners and replacing it with a new, larger exemption. Under the previous rule, sellers were not taxed if they sold their primary residence and purchased a new one that was of equal or greater value. Additionally, homeowners aged 55 or older were granted a onetime exemption of $125,000, even if they did not purchase a new home. This previous rule incentivized selling, as individuals could avoid capital gains so long as they reinvested in another property.

Many homeowners were initially excited when the previous system was replaced with a capital gains exemption on their primary home of $250,000 per person, or $500,000 for a married couple filing jointly. This change was viewed as a major concession and generally addressed the appreciation in home values, resulting in Silicon Valley sellers rarely paying taxes on capital gains in the late 1990s. However, as home prices have outpaced inflation, particularly in Silicon Valley, and the $500,000 exemption has not been indexed to inflation, sellers now face considerable tax burdens on their gains. The explosive growth of median home prices in Silicon Valley underscores the limited protection provided by the $500,000 exemption. For instance, in 2001 the median price of a single-family home in San Mateo County was $590,000. Today it stands at $2,455,421, representing a more than 316% increase, while the exemption amount has remained static. Clearly, capital gains can be substantial in affluent Silicon Valley towns, with places like Atherton experiencing million-dollar jumps in median sales prices during robust individual years.

Another example of California’s higher taxes leading to lower transaction volume can be seen in Los Angeles’ recently enacted “Mansion Tax,” which imposes a 4% tax on properties valued over $5M and escalates to 5.5% for properties over $10M. This tax has greatly reduced sales of luxury properties, as indicated by the most recent available sales data from April 2023-January 2024, which shows a 68% decline compared to homes sold during the same period last year[1].

This ineffective tax not only falls short of projected revenue due to the chilling impact taxes have had on transaction volume, but also results in the state losing the revenue generated from property sales, particularly from the reassessed property tax values that occur each time a California property is sold.

To bolster housing inventory and avoid excessive penalties for homeowners selling their primary residence, one solution is for the federal government (or at least California) to increase the capital gains exemption for married couples when selling your home from $500,000 to $1 million, or ideally $1.5 million. Given that the initial $500,000 exemption was set 26 years ago, it is time to adjust it to account for the significant increase in home values.

Progressives may argue that this change will primarily benefit the wealthy and result in less tax revenue. However, I beg to differ. I believe that increasing the tax exempt amount would stimulate more transactions. As a result, the state could actually see an increase in tax revenue due to the rise in transaction numbers and property tax reassessments, which would help compensate for any loss in capital gains revenue. Additionally, this change would boost liquidity and supply in the housing market, leading to more sales that exceed the new exemption amount and generating additional tax revenue.

Change may be on the horizon. California Representative Jimmy Panetta recently introduced the More Homes on the Market Act aiming to double the exemption from $500,000 per couple to $1 million. This bill is gaining some bipartisan support and might become law in the near future.

Considering the growing illiquidity of the housing market, exacerbated by limited inventory due to burdensome tax policies, it’s imperative to raise the capital gains exemption amount. Failing to act will perpetuate a cycle where fewer sellers are willing to sell due to high taxes, leading to further reduced housing supply, increasing prices, higher taxes, and a disincentive for long-term homeowners to sell. We must break this cycle of diminishing housing inventory by increasing tax exemption thresholds.

by Ken DeLeon