Owner-occupied housing, capital gains, and the Tax Reform Act of 1986

Previous homeowners face a nonlinear (kinked) budget constraint because they can avoid paying tax on the capital gain from the sale of their home if they purchase a more expensive home when they move. Simulation results suggest that the Tax Reform Act of 1986 (TRA86) has enhanced the importance of the capital gains kink by raising the after-tax cost of housing through lower marginal income tax rates while increasing the tax rate on capital gains. As a result, a reduction in the capital gains tax rate would reduce housing demand as some families currently at the kink would buy a less expensive home. Our findings also indicate that the level of excess burden increases with the capital gains tax rate, but that TRA86 reduced the size of implicit price subsidies received by owner-occupiers, and related deadweight loss, by roughly one-half. However, the distribution of benefits and deadweight loss from the favorable tax treatment of housing remains heavily weighted to higher income families. In addition, the size of the implicit housing subsidy and related distortion is sensitive to the level of mortgage rates.