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California’s middle class and our increasingly illiquid housing market

Liquidity – How easily an asset can be converted to cash.

The enduring legacy of the 1980s was its belief in the privatization of public responsibilities and “markets solve everything” approach, which has led to the subjugation of the American working middle-class to a life of being “debt mules” in a tunnel that no longer has a bright light at the end of it.

Sound dire? Let me explain.

In the 1980s, politicians embraced a fantasy about unlimited growth and prosperity trickling down to the middle-class in an economy powered by tax cuts for the wealthy and corporations and broad-based deregulation. That may sound nonsensical, considering all that’s happened since, but then again, the story politicians are selling the middle class, today, about getting the wealthy to pay their “fair share” is equally misguided.

But, you may ask, shouldn’t we be happy that the government is talking about “closing loopholes” and getting rid of “tax deductions” that benefit “the rich?” Well, that’s always the marketing but somehow the financial burdens of their schemes always seem to end up falling squarely on the backs of the vanishing working middle-class, while the truly wealthy carry on, unscathed.

Homeownership -- the backbone of American prosperity

For most American families, homeownership has always been the single most important way to accumulate wealth and it is usually their biggest asset. That didn’t happen by accident. Since World War II, it’s been the result of targeted federal policies, including government-backed loans (Fannie, Freddie, FHA), mortgage insurance, and the ability to write off loan interest costs and local property taxes. These all remain sound public policy. Although there have certainly been systemic barriers based on race, religion, ethnicity, and gender throughout our history, that doesn’t mean the methods themselves, when offered to everyone equally, are not sound. They are incentives to work hard, save, and invest in the future.

The most regressive and anti-wealth building thing local, state, and federal government can do is to increase taxes on homeownership or the purchase or sale of one’s principal residence. But that is exactly what has been happening for the past 30 years. And then everyone wonders why we have a housing crisis.

We hear a lot of talk these days about supply and demand. And although supply and demand and market liquidity are related, they are not the same thing. Politicians should take heed. Tax consequences impact “liquidity” in the housing market. And when demand is high, tax-induced illiquidity drives prices higher.

Taxation, real income, and market liquidity

The first major tax increase on homeownership since the 1950s was the 1990’s change in the calculation of the taxable basis subject to capital gains tax upon the sale of one’s principal residence. Before Clinton’s presidency, if you sold your home and bought another home of equal or greater value within 2 years, you paid no tax on the gain in value on the home you sold. Your “taxable basis” was transferred to your new home.

That tax law produced enormous mobility for Americans and frictionless liquidity in the housing markets. But in the 1990s that all changed, and with those changes the frequency of American middle-class families buying and selling homes and moving began to fall, precipitously.

In other words, the market began to become more illiquid.

Rate-of-American-moving.JPG

If the goal is to provide more housing, why is the government working to discourage it?

The 1990s federal tax law regarding the sale of a principal residence, which remains in effect today, said that if you sell your home, you can deduct $250,000 as an individual or $500,000 as a married couple plus the cost of eligible improvements (not maintenance costs) in addition to what you paid for the house you’re selling, from what you sold it for to determine how much “capital gain” you owe taxes on the sale.

That probably sounded reasonable in the 1990s, because no one ever imagined that housing prices would go up by almost 600% to 800% in the coming 2 ½ decades in most major metropolitan areas in the country (e.g., in San Francisco, Los Angeles, etc.). Statisticians at the time thought it was inconceivable that anyone but the “rich” would be negatively impacted by this tax law change. And no one wanted to talk about indexing those $250k and $500k deductions to a housing cost index (which would have been logical), because that would mess up whatever paper scheme they had concocted to “pay for” whatever other bill they wanted to get passed.

This change in the tax law was certainly not the only reason why American families started to become more “rooted,” as economists referred to it. The other major factor was that this coincided with the beginning of the period when the inflation-adjusted incomes of the average, working, middle-class family began to fall.[1]

So, as middle-class incomes began to fall while the costs of living and the costs of homeownership kept rising, fewer people could afford to buy a home and there was less incentive to sell a home because of the increase in taxes on the sale.

Starting in the mid-1990s, this caused home prices to begin to steadily rise: the beginning of a vicious cycle that has continued to this day. And there has been more nibbling away at the edges of housing affordability, over the years. Almost unnoticed by the media, the interest paid on home improvement loans was also, suddenly, no longer deductible.

Now add to that the impact of the aging Baby Boomer demographic and we have a perfect storm. As we age, we move less often but when we do move it’s usually to someplace that’s smaller. For decades, the supply of “family homes” was fed by this “move-down” market. But in the past 15 years, there has been an increasing interest in “aging in place” and consequently a deceleration of the number of larger homes for sale. Changes in the tax codes that contributed to these trends have largely remained unexamined.

Boom and Bust

After the dramatic run-up in housing prices in the early 2000s, came the global banking crisis and housing crash of 2008. Subsequently, hundreds of billions in bailouts went directly to the top of the pyramid (major financial institutions), while the real pain was endured by the majority at the bottom, particularly the working middle class who still made enough to disqualify them from government assistance, but not enough to resume the lifestyle they’d had before the crisis. In addition to foreclosures, loss of investment and 401K values, and job losses, the lack of personal financial liquidity of working middle-class families was yet another reason why the aftermath of the 2008 financial crisis doubled down on housing market illiquidity.

Even as interest rates have continued to decline (which some economists credit to our being in a long-term deflationary environment) -- a saving grace to aid in refinancing and reducing debt -- the benefits have been more than offset by the overall financial devastation and “asset inequality” that separates the haves from the have-nots.

The truth is that housing market liquidity has never recovered from the 2008 debacle, evidenced by the dramatic rise in home prices even though real interest rates are now negative. (Bank of America just released a study that claims that interest rates are currently at the lowest level in 5,000 years)

Yes, savings rates are very high, historically, but perhaps that is more a sign of fear and mattress stuffing than spending potential. As an example, consider that over the past decades, as Japan has struggled to come out of its endless recession, savings rates in Japan have remained at a very high level.

We refer to the events of 2008 as the “great recession.” Yet, less than a decade later, the trauma was apparently just a faint blip in the rearview mirror of government accounting. By 2017, Congress decided that “rich” homeowners no longer needed to be able to deduct state and local taxes from taxable income, over a fixed amount--the so-called SALT deduction--so that deduction was eliminated.

The elimination of a tax deduction is a tax increase by another name, and as always, this attempt to punish the rich fell disproportionately on the backs of middle-class homeowners living in major metropolitan areas, who were, in fact, already leveraged to the hilt to own a home and needed those deductions to make buying a home possible.

At the same time, the working poor and middle-class pay a far higher percentage of their wealth and wages/earnings in taxes (income tax, sales tax, property tax, fees, etc.) and for necessities (utilities, food, healthcare, insurance, etc.) than the wealthy, whose earnings come mostly from tax-sheltered investments, dividends, sales of stock, borrowing against assets, and other benefits: not from having a “job.” And after all, if one owns multiple homes in multiple states or even countries, the SALT tax is not going to be the most important thing to affect your decision about where to have your primary residence.

As we know, the elimination of the SALT deduction (a tax increase) was just another scheme concocted to pay for another tax cut for the super-wealthy and corporations. It never had anything to do with middle-class families in major metropolitan areas: the working backbone of our economy.[2]

Welcome to the San Francisco Bay Area or Los Angeles or any major city, circa 2021

Today, skyrocketing prices of homes and condos have left tens of thousands of owners in major metropolitan areas, who purchased homes 20 or 30 years ago, staring down tax bills upon the sale of their primary residence that are greater than what they paid for it. The majority of those homeowners are seniors and families who could not afford to buy the home they now live in. And most of those seniors live on some form of fixed income, such as Social Security, a pension, or retirement savings—a far cry from being “rich” as housing advocates like to label them.

Many seniors would like to sell their homes and move into something less expensive and smaller nearby to stay close to family and friends. But (1) for-profit developers are not building that kind of housing (luxury homes and condos are more lucrative), (2) nonprofit housing developers are not building that kind of housing (they need to build large, low-income, multifamily projects to get tax credits and grants), (3) the financial incentives to sell are diminishing, and (4) the latest proposals to “tax the rich” coming out of Washington DC and Sacramento are going to double down on the disincentives. And this is impacting all demographics.[3]

The latest “tax the rich” scheme is to double the tax rate on capital gains: the sale of assets held for more than one year—e.g., stocks, bonds, and real estate. This sounds “equitable” because the media has taught us that the rich get away with not paying their “fair share” by owning so many of these kinds of assets. So, the idea is that anyone who has a capital gain of $1 million or more in any single year should pay 43.4% federal tax on those gains. In California, where all capital gains are taxed as ordinary income, that would add another 13.5% on top of that, for a total of a 56.9% tax rate.

So much for “No one making less than $400,000 a year will see an increase in taxes.”

How will all this work in real life?

In Mill Valley, where I live, about 25% of the population is over 65 and the median age is 48.7 years. The majority of residents are homeowners (single-family, townhomes, or condos). I’ve spent time talking with my neighbors about their plans now that their kids have left the nest. Twenty years ago, most would have said they will someday sell their home and take their nest egg and move someplace to retire. Today, many of them say they won’t be selling their home, particularly if the capital gains tax is doubled. They intend to borrow against their home, reverse mortgage it, turn it into a rental, or whatever else they can possibly do to avoid a sale because the taxes due would be disproportionately (absurdly?) high.

People are not dumb. They can do basic math. According to Redfin, the median home price in Mill Valley is now $1.9 million. Almost all of my neighbors who are seniors will have a long-term taxable gain of $1 million or more if they sell. None of them are even remotely “rich.” For what they’d have to pay in taxes on a sale they can buy a retirement dream home almost anywhere in the world.

Or consider the plight of one of my neighbors, who extensively rebuilt his home, himself, as the contractor. At the time he did that, he calculated that he’d saved about $250,000 in markups and contractor fees by doing it himself. He was building sweat equity. But now, proposals like doubling the capital gains tax mean he’ll pay a tax rate on his labor that brought about that gain in asset value at almost twice the rate he pays on the salary he earns at his job. Where is the incentive to be self-sufficient and thrifty in that? Where is the incentive to build wealth through hard work?

At the same time, there is also growing sentiment that all the combined taxes and fees and assessments we already pay (local sales tax, fees, state, and federal income tax) are not producing enough benefits, anymore. Our roads and power and sewer systems are a mess, our schools can’t survive without more and more bond debt, even while teachers are being underpaid, our public services continue to be reduced (anyone seen a street sweeper, lately?), and our city is barely functioning and not just because of Covid. Our city’s service agencies were open only about 3 ½ full days a week before the pandemic.

Counterproductive consequences

Like anything else, tax laws can become perverse and produce the opposite of what they are intended to do. There is no question that doubling the capital gains tax rate will have an impact on housing market liquidity (and stock market/retirement account liquidity, as well). Seniors and working, middle-class homeowners in major metropolitan areas in the US, will be disproportionately impacted.

I’m not sure if a single politician in Sacramento or Washington DC has even thought about how lack of market liquidity can and will continue to drive home prices higher. And lobbyists for for-profit developers certainly won’t bother to mention this because higher housing prices are in their best interests.

Our federal and state tax laws are based on a quaint idea that you can pass a law based on fixed, one-size-fits-all formulas and numbers. That kind of thinking is an artifact of the 1950s, when the country was more homogeneous in average income, cost of living, and housing prices. But San Francisco ain’t Scranton, Pennsylvania. What $250,000 buys you in Detroit won’t even cover your down payment on a shack in Los Angeles.

The methodologies our tax laws are using are absurd. And $1 million ain’t what it used to be. If the proposed increase in capital gains tax goes through, without exempting the sale of a primary residence, it will decimate housing market liquidity in all major metropolitan areas.

Do I think that those making extraordinary incomes and experiencing enormous asset value growths should pay more taxes as a percentage of their overall income and wealth? Yes, I do, because their largess is only made possible as the result of generations of public investments of public funds (roads, schools, parks, infrastructure, regulated markets, etc.) gathered from taxing the day to day labor of the working middle-class. But what I'm trying to explain is that doing that effectively will require much more surgically crafted methods than the blunt instruments that our governments, state and federal, are proposing. In other words, it's complicated to ensure that tax law does what it intends to do without significant unintended (poorly thought out) consequences.

The American Dream on life support

Middle-class families have always worked and made sacrifices in the hope of passing along something to their children. Their home, more than any other asset, has always been the best way for most people to create inter-generational wealth. Isn’t that the very foundation of what we call the American Dream?

But now we find ourselves in a world where, according to a very well-funded group of politicians backed up by a vocal and well-financed minority of entitled, mostly white, highly educated Millennials, who call themselves YIMBYs, homeownership equates to being a rich elitist and being a senior who’s concerned about your future means you're a NIMBY.

Another of the latest tax-the-rich schemes is the elimination of the stepped-up basis for heirs upon the death of a homeowner. California has already passed this for state taxes, last year. When you die in California, now, your heirs no longer inherit your home on a stepped-up basis. They must now pay state taxes on your gain in value (Where is that shoebox that mom put all the receipts in for home improvements for the last 40 years?) just as if you had sold it. Your death is now treated as a sale.

For many working, middle-class families, heirs will have to sell their parents’ homes to pay the taxes due. And now the federal government wants to get in on the action, too. Again, all in the name of getting those damn “rich people” to pay their fair share.

And then there is the cockamamie proposal to eliminate the 1031 exchange tax rules for real estate transactions. Unpacking the impacts of that would take a whole other article, but this is another example of self-defeating, politicized thinking.

Suffice it to say, the 1031 exchange law is vital to the liquidity of the rental and affordable housing industry. Without the ability to exchange investment property tax-free there will be gridlock. (statistics show that 1031 exchanges are used by small investors far more often than big corporations)

But not only should the 1031 rules continue to be allowed, particularly for rental housing projects, but we live in a time when the government should be doubling down on the 1031 rules.

As I’ve discussed in the past, if we really want to see a massive amount of private investment flow into the creation of affordable housing, then we need to remove the “like-kind” exchange rules to allow tax-free exchanges of “not like-kind” properties so long as those transactions bring investment to the development of low-income, affordable housing.

Endless disincentives will only result in fewer homes being built and keep more and more homes off the market that might otherwise be for sale, exacerbating the vicious cycle of illiquidity leading to higher and higher prices.

Meanwhile, the great irony is that those who will suffer the most will be the same Millennials, whose single-minded obsessions are to destroy middle-class suburban neighborhoods and “soak the rich” will ultimately destroy any hopes for them to be able to afford a middle-class lifestyle because their favored tax policies will drive homeownership farther and farther out of reach, just at the time when they are reaching the age when they want to settle down and raise families.

As the old saying goes, be careful what you wish for.


[1] It has been estimated that in the past 40 years the inflation adjusted income of the average American middle-class family has fallen more than 13%.

[2] McKinsey estimates that the 250 major cities in the US contribute 85% of the country’s GDP.

[3] For the first time on record, fewer than 10% of Americans moved in a year. US Census.


Bob Silvestri is a 28-year Marin County resident, and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization funded by individuals and nonprofit donors. Please consider DONATING TO CVP to enable us to continue to work on behalf of California residents.