Berkeley homeowner Alice and her husband appear to be sitting on gold. The couple bought their three-story Elmwood home back in 1978 for just $135,000. Today the average price of a home in their neighborhood is more than $1.8 million. But, despite this fact, Alice (whose name has been changed to protect her privacy) says she and her husband can’t afford to move, even though they have considered it over the years.
“We couldn’t afford to move because the housing prices kept increasing,” Alice explained. “We would have had to downsize — in a big way.”
How can a homeowner sit on so much equity yet be unable to move? While there are many factors contributing to the housing crisis in the Bay Area — including a severe shortage of new housing construction — one often-overlooked reason has to do with state and federal taxes.
Passed in 1978, Proposition 13 froze property tax values at a home’s 1976 assessed value, and capped increases at no more than 2% per year. When a home changes ownership, its property taxes are set at 1% of the sale price, plus the 2% yearly cap in increases. This has created huge tax breaks for longtime property owners like Alice, but it’s also had unintended consequences.
Matt Regan, senior vice president of public policy at the Bay Area Council, says many senior citizen homeowners have effectively become “prisoners” of Proposition 13.
“They can’t afford to move because the new home will be assessed at 2017 property rates, and they can’t afford to pay that so they’re trapped in these big expensive homes,” Regan said.
Alice said her property tax bill currently amounts to about $6,000 per year, based on an assessed value of just $253,719. If she were to buy a new home worth the value of her existing home — say, for $1 million — her property taxes would increase by about 66%, to $10,000.
Compounding this problem are capital gains taxes. When a homeowner sells their property, there may be a tax if the value has appreciated. The Taxpayer Relief Act of 1997 created an exemption of $250,000 for an individual and $500,000 for a married couple. But that isn’t much help in the Bay Area, where gains can easily exceed this amount. In Berkeley, the median sale price of a single family home was less than $600,000 in 2012; today, it’s more than double that, topping $1.2 million. (In order to be eligible for the exemption, homeowners must have resided in their home for at least two out of the last five years.)
Take the example of Alice and her husband: Let’s say they sold their home for $1.8 million. The general formula is to add the original purchase price, costs of sale, and costs of capital improvements to calculate the basis. (Save those receipts!) That amount is deducted from the sale price, leaving the taxable amount. Just assume that the calculated basis on their $135,000 house amounts to $435,000. That would leave them with a gain of $1,365,000. Their net taxable amount would be $865,00 after exempting $500,000 because of their status as a married couple. Depending on the tax bracket they fall in, they would have to pay a federal capital gains tax rate between 15 and 23.8% on the remainder. Combined with California’s capital gains taxes — which could be anywhere from 1% to 13.3%, depending on the tax bracket they fall under — Alice and her husband could end up paying as much as $320,915 in taxes on their $865,000 gain. (Although capital improvements can help reduce capital gains taxes.)
This scenario is not uncommon. According to a survey by the California Association of Realtors, some 92% of baby boomers in California have equity in their homes, and of those, 35% have equity of $250,000 and above.
Forrest Bell, an investment advisor and financial planner with Oakland-based Bell Investment Advisors, says capital gains taxes in particular are a major consideration for his clients who are thinking about moving. “The weight and size of that [capital gains tax] number gives people pause, and often times what it does is it forces people to think harder about staying in their homes,” said Bell.
Prop 13 creates “a huge penalty for selling”
Essentially, Proposition 13 and capital gains taxes have created “a huge penalty for selling and moving,” said Kenneth Rosen, chair of the Fisher Center for Real Estate and Urban Economics at UC Berkeley’s Haas School of Business. According to Rosen, baby boomers are also working longer and living longer and healthier lives. “They’re not ready to move and retire,” he said. “They’re waiting longer.”
This has all sorts of implications for the economy and the real estate market. Most immediately, it has contributed to the scarcity of available homes for sale.
According to data from Red Oak Realty, during the second quarter of 2017 it would have only taken about 21 days to sell all the available inventory of single-family homes in the East Bay. As such, competition for housing has become fierce. Homes are selling faster and for more money than ever before. In Berkeley, homes are selling on average for 22% above list price and in just 20 days on the market, according to Red Oak Realty. Not surprisingly, homes are out of reach for most buyers. These days, a household making the median income has only 21% of the income necessary to buy a home in Alameda County. Back in 2011, it was double that amount.
Regan says older homeowners are essentially tying up the large homes that would otherwise be bought by young families. That, combined with the fact that there’s not nearly enough new housing being built, results in young families having to move far away from the urban centers where they work. “Those families are forced to places like Brentwood and Antioch, which are the only communities that are building family-friendly housing,” said Regan.
This has obvious impacts on the environment. While it would be more sustainable for people to live in high-rise condos in urban areas near where they work, instead young workers are being forced to commute long distances in their cars, adding to greenhouse gases. Some 170,000 people commute daily into the Bay Area from outside its nine counties, says Regan.
Others are forced to flee entirely. Regan said 250,000 families a year leave California — 70,000 of them to Texas alone — and most of them make less than $50,000 per year. They cite the lack of affordable housing as the number one reason for their departure.
And California families that relocate to Texas pollute more because municipalities there don’t have the renewable energy portfolios that exist here. “Every family is tripling their greenhouse-gas production,” said Regan.
Employers are also leaving: In May, Jamba Juice announced it was moving its company headquarters from Emeryville to Frisco, Texas partially because of the lower cost of living. And in March, tech company Zapier offered its employees a $10,000 “de-location” package to move outside of the Bay Area.
Another unintended consequence of Proposition 13 is the “fiscalization of land use,” Regan continued. Prior to Proposition 13, property taxes were a reliable source of income for local governments, but after Prop 13 passed, property taxes now go to Sacramento and come back pennies on the dollar. In 2016, the effective tax rate in all nine counties of the Bay Area was lower than the national average. In Alameda County, it was just .75%. This starves local governments of desperately needed tax revenue, and it’s why a wealthy town like Moraga recently had to declare a fiscal emergency.
“In many instances, housing doesn’t pay as much as other uses,” said Regan. So cities set aside land for industrial and commercial uses because those tax revenues stay local. According to a recent article in the Los Angeles Times, the city of Brisbane would net $8 million more per year in tax revenue if they developed 640 acres of land into a commercial space rather than a proposed 4,400-unit housing project, a consultant found.
For older homeowners, there are ways around Proposition 13. Proposition 60 gives California homeowners age 55 and older the ability to transfer the base year value of their current primary residence to their newly acquired property if they move within their county and their new home is their primary residence. Proposition 90 extends this rule to homeowners who move to and from specific counties, including Alameda, El Dorado, Los Angeles, Orange, Riverside, San Bernardino, San Diego, San Mateo, Santa Clara, Tuolumne, or Ventura.
But there’s a catch: Both propositions 60 and 90 require homeowners to move within a two-year period, and the new property must be of equal or lesser value than the old residence. The other restriction is that a homeowner can only take advantage of Proposition 60 or 90 once, unless the homeowner becomes “severely and permanently disabled after the date of the original claim and had to move because of the disability,” according to the California State Board of Equalization.
“So the good news is, if you’re in Marin County or San Francisco and you’re over 55, you can bring your tax basis here [to Alameda County]” said Art White, managing broker of Red Oak Realty. “You may still pay the capital gains, but you won’t have to pay a new assessment.”
That means if Alice and her husband sold their Berkeley home and bought a residence for $900,000 in Oakland, they could transfer the $253,719 base year value from their prior home, keeping their property taxes low, although they’d still have to pay the capital gains taxes. (Of course, finding a home that will be of equal or lesser value to their prior home, and still meet their needs, is another challenge.)
It’s easy to see why homeowners aren’t moving and are opting instead to hold onto their property in order to leave it to their heirs. When parents die and leave property to their children, the property’s tax basis is “stepped up” to its current value, meaning the children can avoid capital gains taxes if they sell the home.
Some property owners may also be eligible for doing a 1031 exchange. This allows an investor to sell a property and reinvest the proceeds in a new investment property, deferring all capital gains taxes in the process. According to Bell, a principal residence can be considered a legitimate investment property if the homeowners move out of their home and rent it for two years. But that requires the homeowner to move, find another place to live, and likely put their belongings in storage. “There’s a level of inconvenience you have to tolerate to make it work,” said Bell. Plus, they wouldn’t be able to live in the new property.
These options clearly won’t work for everyone. And they certainly won’t solve the Bay Area’s housing crisis. So what should be done?
Regan says the governor should declare a state of emergency on housing and take away local control so that local governments and NIMBY (not in my backyard) residents can no longer roadblock new housing developments, especially so-called “smart housing” near public transportation. Environmental restrictions for these developments could also be bypassed, and cities should be up-zoned to allow denser developments.
Need better ways to fund affordable housing
There also needs to be better ways to fund affordable housing, Regan says. One idea is to spread the cost of affordable housing to everyone who owns land, rather than having the burden on the last person to move into a community. That would make it more equitable. He also suggests a “carrot and stick” approach, for example, rewarding cities that permit housing with extra money for roads, and withholding money for transit and other infrastructure projects to cities that want to maintain their low-density character.
“We cannot continue to promote transit-oriented development on the one hand and give money to cities that ignore it on the other,” said Regan.
Economist Rosen suggests allowing California residents to transfer their tax basis to anyplace in the state. And instead of a capital gains tax, he recommends a small transfer fee. He also thinks Proposition 13 should be amended to allow annual increases of up to 5% a year instead of 2%.
The responsibility to create more housing lies not just with government but also with residents themselves. “It’s nice that people are driving Priuses,” said Regan, “but when it comes to making real sacrifices — allowing that 400-unit building in your community — are Bay Area liberals willing to make that sacrifice?”
The failure to do so may have severe consequences on the local economy. “It’s going to kill the goose if we don’t solve the housing affordability issue we have,” said Rosen. “It’s going to make it incredibly difficult to get people to come here…. It’s a housing emergency that’s going to restrict our growth and economic performance over time.”
Even without state and federal tax burdens, longtime homeowners like Alice and her husband are choosing to stay in the Bay Area anyway. Bell said some of his clients who consider moving to other states end up with a newfound appreciation for the area. “There’s a reason property values are high in California,” he said. “It’s an unusual mix of culture and weather and opportunities, whether to be in nature or wine country or a nice urban environment, that is attractive.”
Note: To understand your capital gains liability, consult your personal tax advisor. And more information on propositions 60 and 90 rules can be found at your local county assessor’s office.