from The Herald Tribune: U.S tax break may have helped housing bubble

U.S. tax break may have helped housing bubble

By Vikas Bajaj and David Leonhardt

"Tonight, I propose a new tax cut for homeownership that says to every middle-income working family in this country, if you sell your home, you will not have to pay a capital gains tax on it ever - not ever."

- President Bill Clinton, at the 1996 Democratic National Convention

Ryan Wampler had never made much money selling his own homes.

Starting in 1999, however, he began to do very well. Three times in eight years, Wampler - himself a home builder and developer - sold his home in the Phoenix area, always for a nice profit. With prices in Phoenix soaring, he made almost $700,000 on the three sales.

And thanks to a tax break proposed by President Bill Clinton and approved by Congress in 1997, he did not have to pay tax on most of that profit. It was a break that had not been available to generations of Americans before him. The benefits also did not apply to other investments, be they stocks, bonds or stakes in a small business. Those gains were all taxed at rates of up to 20 percent.

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The different tax treatments gave people a new incentive to plow ever more money into real estate, and they did so. "When you give that big an incentive for people to buy and sell homes," said Wampler, 44, a mild-mannered native of Phoenix who has two children, "they are going to buy and sell homes."

By itself, the change in the tax law did not cause the housing bubble in the United States, economists say. Several other factors - a relaxation of lending standards, a failure by regulators to intervene, a sharp decline in interest rates and a collective belief that house prices could never fall - probably played larger roles.

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

Vernon Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for "fueling the mother of all housing bubbles."

By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can't-miss investment for much of the last decade, it was also a tax-free one.

Together with the other housing subsidies that had already been in the tax code - the mortgage-interest deduction chief among them - the law gave people a motive to buy more and more real estate. Lax lending standards and low interest rates then gave people the means to do so.

Referring to the special treatment for capital gains on homes, Charles Rossotti, the Internal Revenue Service commissioner from 1997 to 2002, said: "Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?"

The provision - part of a sprawling bill called the Taxpayer Relief Act of 1997 - exempted most home sales from capital-gains taxes. The first $500,000 in gains from any home sale was exempt from taxes for a married couple, as long as they had lived in the home for at least two of the previous five years. (For singles, the first $250,000 was exempt.)

Wampler said he never sold a home simply because of the law's existence, but it played a role in his decisions and also became part of his stock pitch to potential customers who were considering buying the homes he was building in the desert. He would point out that the tax benefits would increase their returns on a house, relative to stocks.

"Why not put your money on the highest-yielding investment with the highest tax benefit?" he said recently.

During the boom years, he prospered. But today he owns 80 acres of land on the outskirts of Phoenix that he cannot sell. He owes $8 million to his banks, which may soon foreclose on his land.

"I am literally dying on the vine," he said.

The change in the tax law had its roots in a Chicago speech that Senator Bob Dole, Clinton's Republican opponent in the 1996 presidential election, gave on Aug. 5 of that year. Trailing Clinton in the polls, Dole came out for an enormous tax cut, including an across-the-board reduction in the capital-gains tax.