Smarter Tax Breaks for Homeowners, Young and Old

Even though residential property prices have recently simmered down in many states, politicians all over the country are falling over themselves to cut or curb property taxes. Many states already have laws on the books to limit tax or assessment increases to the inflation rate, but there are plenty of others where sticker shock hits homeowners every time they see their tax bills. And they are giving politicians an earful.

Meanwhile, half of surveyed mayors call housing affordability their biggest challenge. The issue, magnified by ever-rising property tax bills, is particularly acute for would-be first-time homebuyers. At the other end of the age spectrum, older homeowners are locked in to their properties by the prospect of painful income taxes on six-figure capital gains from a sale. There’s an opportunity to address the needs of both cohorts with targeted state and federal tax breaks.

States that have not already installed property-tax revenue caps of some kind can learn a lot from the successes and failures of the others that have tried various ways to curb runaway increases in local levies. Those methods have been explained and analyzed here and elsewhere and need little elaboration: Cap total property tax revenues in the aggregate, using a CPI-based formula that permits additional revenues from new construction and improvements. Allow local officials to vote an override with a supermajority or leave that option open to their voters. States with income taxes could also use AI to tailor relief to specific homeowners. It doesn’t need to be more complicated than that, to achieve rough justice when home values skyrocket from economic forces beyond local control.

But from a purely financial demographic standpoint, property tax curbs and cuts are regressive. The national median household incomes of homeowners are double those of renters, and only 10 percent of property owners hold half the valuations overall. Home equity is a form of wealth: about half of middle-class assets overall, and racially skewed. So providing across-the-board relief from taxes on asset appreciation to the upper two-thirds of a state’s wealth holders, with even-more-regressive tax breaks for the owners of income-producing property, is hardly what anybody could honestly call tax reform. Current circuit-breaker laws have little to do with housing affordability in a demographic context.

Experience has shown that the more draconian parcel-specific tax limitation measures, like California’s Proposition 13 enacted in the 1970s, can create huge inequities over time. States that freeze individual property assessments, and especially those that bestow those freezes to paper entities that can be transferred to new owners behind the veil of legal fiction, ultimately shift the burden of local taxation to newcomer residential owners. The tax bill for a retiree California homeowner can now be less than one-fifth of what the young family living next door pays for a house with similar floor space. New commercial properties can suffer the same relative disadvantage, which creates huge windfalls for grandfathered landlords and companies, at the expense of local schools in particular.

As a California retiree myself, I appreciate the peace of mind that Prop. 13 gives me that my costs of homeownership are pretty much locked in for coming years, but legislators and voters out here would be far wiser to limit those perks to individual owners and allow assessments for nonresidential owners to reflect current value, not the price of property in the 1970s. Somehow the advocates of tax reform have never been able to show voters that it would be in their self-interest to limit Prop. 13 to owner-occupied residential property by requiring the incremental revenues from unlocked commercial and industrial assessments to be used for overall tax rate reductions — or to prudently pay down governments’ debt service and unfunded retirement liabilities, which would benefit every taxpayer in the longer run.

There is no equitable or populist justification for allowing LLCs, family partnerships and various other legal fictions to escape a reassessment when underlying ownership changes hands under the covers. A good argument can be made that no more than one or two condos or single-family rental properties with the same owner should enjoy assessment limitations, which might drive rents higher but also increase the available housing stock for first-time purchasers. Those are reforms that every state with such assessment loopholes should start addressing in coming years as these contrived “horizontal inequities” keep widening.

Targeted Incentives

This still leaves us with the national shortage of affordable housing and the hurdles that housing inflation has brought to the youngest and oldest age cohorts. First-time buyers face an affordability gap far deeper than those posed to previous generations. For them, state laws to provide targeted property tax relief in sensible ways could go a long way to support the American dream of homeownership. At the same time, we need to find a way to release the stored value of single-family homes owned for decades by baby boomers who might prefer to sell and downsize if it were not for capital gains taxes that keep them locked in.

Let’s start with the prospective first-time buyers. State legislatures should enact property tax relief that exempts them from taxes on a primary residence up to some specified dollar level, perhaps $6,000 annually for a period of five years with a three-year phase-down beyond that if they remain qualified. Limits on household income and personal assets should be some multiple of the statewide median so that the exemption is truly confined to the middle class and not available to trust-fund babies.

Congress could also help on this front with a parallel income tax deduction for first-time buyers’ mortgage interest, in addition to their standard deduction, because most of those who qualify would still not have enough to itemize. Like it or not, the benefit would be similar to the new tax exemptions for tips, overtime and car-loan interest. Income-tax states should follow suit.
To promote more housing supply, Congress and the 44 income-tax states could also provide an income tax credit of perhaps $5,000 to homebuilders on their new-home sales to first-time buyers at prices below the statewide average, provided they annually complete construction of more housing than their company’s recent historical average (including production by affiliates to avoid shell games). That combination could boost the net profit margins on such sales by a factor of 50 percent in many cases.

To further encourage new construction of starter homes, the states could also grant or underwrite a buyer-specific construction-period property tax rebate to builders that would be credited to a first-time purchaser’s escrow as a supplement to equity (not a replacement of their down payment). That design would financially benefit both parties in the transaction as well as the mortgage lender.

For this to work, the states would have to reimburse local school districts for lost revenues or allow the affected localities to raise property taxes on others, such as non-residential owners. (The latter would again be impossible in California because of Prop. 13, but could be workable elsewhere.) A minimum cash down payment of 10 percent should be required, so that lenders are not boxed into a solvency dilemma of foreclosing on buyers who cannot sustain their payments once the property tax exemptions expire.

The Downsizing Dilemma

As for a tax break for older homeowners looking to downsize, this would require federal legislation. Although the states with high income tax rates might be able to offer some worthy incentives, those alone are unlikely to move the needle. Presently, IRS rules allow home sellers to escape capital gains taxes on profits of up to $500,000 for married couples, and this can be done every two years. The problem for long-time owners is that many of them now have locked up profits on their home values well above that level.

A once-in-a-lifetime statutory exclusion of capital gains up to a million dollars — or twice each state’s median property prices if greater — and limited to a finite period of perhaps three years would give those born before 1965 a chance to cash out and downsize. That would provide a six-figure tax incentive and would benefit most local governments with tax limitations by raising the assessed value of those properties to market levels based on the new sales price.

California’s Prop. 13 was tweaked in 2020 to allow homeowners aged 55 and above to carry their frozen property assessments with them to the next home at the same or lower value. Florida has a somewhat similar cap-transfer provision, but assessors and critics say that one has proved to be unduly complicated. Similar straightforward, workable provisions would help unlock sales of at least some of the elders’ empty nests in maybe a dozen other states. All of this would be a realtor’s dream, of course.

As for new housing construction, it will take multiple coordinated strategies to materially increase the supply. States and localities need to keep streamlining their land use and permitting processes, and will have to absorb some modest budget hits if they want to get more serious about the housing shortage.

There’s just no free lunch for politicians when it comes to boosting new housing construction, and all these incentives combined will still fall short of making homeownership possible for many who lack the incomes and savings this requires. Nonetheless, a combination of these ideas would be a good place to start, with very little downside.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.