Capital Gains Conformity Will Increase Revenues While Benefitting Taxpayers

By Stephen Kroes

It was a fiscal analysis that, taken in a vacuum, might cause some anxiety among those who fret over proposals that reduce tax dollars. It was estimated that conformity to federal changes in capital gains taxation on principal residences would be a major hit on government revenues in California - $205 million over three years.

However, as Paul Harvey would say, here is the rest of the story.

Conforming California tax law to recent federal changes in capital gains taxation on principal residences would cause an increase in property sales, resulting in new property tax revenues that would far exceed any state income tax losses. Cal-Tax estimates that property taxes would increase by $429 million over three years.

Therefore, Cal-Tax said in a letter to the Legislature, conformity should be adopted immediately, and it should be a permanent change.

Editor's Note: The Legislature and Governor Pete Wilson agreed on a tax-relief package that included, as Cal-Tax advocated, permanent conformity on principal residence capital gains taxation, not the one-year plan that had been part of an earlier proposal by Senate President Pro Tem Bill Lockyer. This provision was part of legislation that passed on September 13 in the tax-relief package.

The following analysis is taken from Cal-Tax's letter:

According to the Franchise Tax Board (FTB), a survey shows that 4 percent of homeowners would sell their homes within three years if California conforms to federal changes that exempt from income taxation the proceeds from selling a principal residence, up to $250,000 for single taxpayers and $500,000 for married (joint filers) taxpayers. This would amount to over 200,000 additional homes sold in the next three years.

If California does not conform, 2 percent of homeowners would still sell their homes because of the federal tax incentive (over 100,000 homes). By counting the windfall revenue that California would now receive if those 2 percent of homeowners sold their homes and the state does not conform, FTB estimates that conformity would cost the state $205 million over three years. These would be one-time losses caused by the release of a pent-up supply of homes.

Not included in FTB's analysis are the gains that would result from property tax assessment increases triggered by the change in ownership of those 200,000 homes. Because of Proposition 13's limits on assessment increases, homes that have been held for some time are assessed for property taxes far below their actual market value. A 1993 study by the California Policy Seminar, affiliated with the University of California, showed that the "ratio of market to assessed value is 1.80..." In other words, the average property sold (and consequently reassessed) will bring in 1.8 times more property tax than it did before it was sold.

Using figures from the Board of Equalization's report on assessed values of properties with homeowners' exemptions, Cal-Tax estimates that the average home sold would produce over $1,100 in new property tax revenue annually. This would produce increased property tax revenues of $429 million over the three years that FTB says income taxes would decrease by a cumulative $205 million.

This estimate is on the conservative side, since many homes that sell because of changes in capital gains taxation are likely to have even more pent-up value than the average home. These are likely to be homes that people have held for a long time because they did not want to face a large capital gains tax. Therefore, the resulting revenue could be much greater than this estimate.

Even state government would be a net "winner" from the change, as the schools' share of property tax increases would total about $223 million over the three years, exceeding the projected loss of income tax revenues and providing a net benefit to the state general fund. In addition, the lost income tax revenues would be one-time in nature, while the increased property tax revenues would continue year after year.

Earlier this year, local governments advocated a return of $280 million in property tax revenues that the state had shifted to schools. They did not succeed, largely because of budget concerns. Now the Legislature is faced with an opportunity to make a tax law change that would provide at least $200 million to local agencies over the next three years without harming the state budget. Indeed, this change would provide a net benefit to the state budget while providing relief to taxpayers and increasing revenues to local agencies.

This change should be permanent. According to the FTB, one-time relief for 1997 would only allow about 10 percent of potential sellers to receive this tax relief. Therefore, a temporary change would not provide the full benefit of increased property taxes to local governments.