Jay:
Thank you for your thoughtful response to my slightly intrusive question.
In the interests of full disclosure, until about 12 months ago, I too was convinced that a crash was coming. My hedge strategy was to sell my large, fully-valued (in my opinion) residence in a pricey Boston suburb and move into a smaller house with fix-up potential - the proverbial least expensive house on the street. This freed up a good chunk of cash, tax free. Extrapolating this experience was largely responsible for me changing my mind and deciding that we were going to avoid a crash. Please allow me to explain.
A very important factor in current US economic performance that is perhaps not too visible to those outside the US is the Taxpayer Relief Act of 1997. This changed the tax treatment of capital gains on a primary residence in a very, very significant way. Prior to 1997, capital gains on a primary residence were fully taxable at the capital gains tax rate. The tax due was deferrable in full, however, providing that the seller purchased another primary residence at a higher price than the sale price of the prior primary residence. The tax was also subject to a one time exclusion for a married couple of about $154,000, I think. The practical effect of this was that homeowners would avoid moving unless they could trade up and then, when they traded down as empty-nesters, they would pay tax on a very sizable capital gain. The Taxpayer Relief Act of 1997 has changed all of this. The capital gain on the sale of a primary residence is now TAX-FREE, up to a maximum capital gain of $500,000 for a married couple. What's more, this tax-free capital gain can be repeated EVERY TWO YEARS. Think about the effect this has had on house prices and also on people's economic behavior. First of all, the implicit portion of the projected capital gain that would have been lost in capital gains tax on a future sale is being arbitraged into house prices across the country. The result of this is a one time acceleration in the rate of increase in house prices that will continue until the arbitrage process is complete. Second, people's house buying behavior has been totally changed as there is now NO PENALTY for trading down. Prior to the 1997 Taxpayer Relief Act, for example, my wife and I would have had to pay a six-figure capital gains tax following our recent trade-down. Now we can trade down tax-free, work to improve our new residence using contractors or the sweat of our brows and capture the results of our labors tax-free. There is a tremendous incentive for entrepreneurial homeowners to treat their residence primarily as a leveraged investment. In aggregate, this results (I believe) in people selling their primary residence more frequently with the attendant economic activity this generates and also an ongoing country-wide effort to improve the quality of the housing stock. I believe that this factor may largely explain the resilience of residential real estate pricing, of construction spending and of consumer spending during what has been a very nasty recession for manufacturing and for telecomm. |
