Housing Notes: How Capital Gains Tax Locks In Listings

How Did Capital Gains Tax Work Before 1997

Fair warning – my eyes tend to glaze over when the topic of taxes comes up. Here’s a little history.

Capital gains taxation began in 1913, when the ratification of the Sixteenth Amendment allowed Congress to enact the modern federal income tax through the Revenue Act of 1913. Capital gains only became a distinct tax category in 1921, with a preferential capped rate of 12.5 percent for gains on assets held more than two years. 

Before the 1997 Tax Act and Home Sale Gains, homeowners avoided capital gains tax through two mechanisms: an uncapped “rollover” rule that deferred tax indefinitely as long as you reinvested sale proceeds into a replacement home of equal or greater value, and a once-in-a-lifetime $125,000 exclusion available only to sellers age 55 or older. This, in effect, encouraged homebuyers to always trade up but was repealed in 1997. Boomers grew up with the mantra of homeownership, which was incentivized by favorable tax incentives.

Another “Lock-in” Effect

Most of us are familiar with the mortgage-related “lock-in effect,” where homeowners who got a 3.75 percent to 4 percent mortgage rate during the pandemic era are reluctant to give that up for the current 6.7 percent rate.

The capital gains tax can keep homes off the market, too, because it also creates a “lock-in” effect: an owner with a large unrealized gain may decide that selling is too costly, even if the house no longer fits their needs. This problem stems from the fact that the tax was not adjusted for inflation, and home prices have risen much faster than inflation over recent decades.

When an owner sells a primary residence, taxable gain is generally the sale price minus the home’s adjusted cost basis: what they paid + capital improvements + certain transaction costs. That was the story for nearly a century. But in 1997, Congress capped it. Federal law let sellers exclude up to $250,000 of gain if single or $500,000 if married filing jointly, provided they meet certain tests. 

The problem is that home prices have risen faster over the past few decades, and the ‘97 cap was fixed so it does not grow with inflation. Yet the median sales price of an existing single-family home was $145,000 in 1997, and it is now $440,300 in 2026, a 204 percent increase, tripling in value over this period. Inflation over the same period grew only 108 percent, so even an inflation adjustment wouldn’t have stopped the issue facing the housing market. The exposure to the tax above the basis would still keep houses off the market for tax management purposes.

Basis In Action

Here’s an example:

A married couple bought for $150,000 and later sells for $1.1 million. Suppose they have $100,000 in improvements and $60,000 in selling costs:

$1.1m−$150,000−$100,000−$60,000 = $790,000 gain

After the $500,000 exclusion, roughly $290,000 remains taxable. That tax bill reduces the proceeds available for a downsized home or a retirement move. It can make staying put financially preferable even when the house no longer fits the household, such as for empty nesters living in the same home where they raised all their kids.

Federal Reserve research found evidence that the 1997 policy change may have unintentionally locked in owners whose gains exceeded the maximum exclusion. The “lock-in” effect of capital-gains taxation means that taxpayers may retain appreciated assets rather than sell and reallocate them.

The Taxpayer Relief Act of 1997 (TRA97) may have generated an unintended lock-in effect on houses with capital gains over the maximum exclusion amount.

Nationally, Inventory (Existing+New) Is Approaching Average

The reality is that while supply is approaching the long-term average of the past 35 years, listing inventory trajectories vary a lot by region. I’ve talked about this a lot here, and I’ve always marveled at how many analysts treat the US housing market as one big, homogeneous market, as illustrated in this chart.

Trends Look Very Different By Region

While listing inventory is growing modestly in the Northeast and Midwest, it remains 40 percent below pre-pandemic levels. But the narrative is changing quickly for the South and West, which saw significant growth over the past two years; they are going negative in 2026 and are roughly at pre-pandemic parity.

What’s On The Horizon To Reduce Tax Exposure?

• Nest Egg Protection Act: Proposes a temporary $1 million exclusion for qualifying homeowners aged 65 and older who have owned their primary residence for 25+ years.
• More Homes on the Market Act: Proposes permanently doubling the basic exclusion from $250,000 to $500,000 for single filers, and $500,000 to $1,000,000 for married couples filing jointly, with ongoing inflation indexing.
• No Tax on Home Sales Act: Proposes removing the cap entirely on capital gains exclusions for primary residences.

According to Google Gemini, the odds of enacting major tax exclusion expansions in the near term are under 25 percent, but regulatory updates are highly likely with odds above 80 percent, so there may be some relief. Of course, the 2025 Big Beautiful Tax Bill Act has helped balloon the national debt to a record $40 trillion. Yet federal spending is projected to rise about 6 percent in FY2026, even as concerns about deficit reduction persist and are helping push mortgage rates higher. So cutting capital gains taxes by $4.5 trillion with lower tax revenue seems like a distant possibility. However, since housing market-related activity accounts for up to 18 percent of GDP, it is probably worth thinking about this relief in some form sooner rather than later.

Final Thoughts

The Taxpayer Relief Act of 1997 replaced pre-1997 rollover provisions with fixed $250k/$500k primary residence exclusions. Because these caps were never indexed to inflation, massive long-term home appreciation has created a tax “lock-in” effect that discourages owners from selling. This makes the limited inventory picture even worse. This dynamic also restricts entry-level starter inventory for younger buyers, traps wealth in illiquid property rather than productive capital markets, and reduces broader housing mobility across regional labor markets.

The Actual Final Thought – What a time we’re living in!