By changing the tax rules on capital gains from the sale of primary homes and homes passed down to heirs, Congress can help pry open the single-family housing market.
Drive through almost any established suburb in the United States, and you’ll see the pattern: single-family homes large enough for growing families occupied by just one or two retirees whose children left the nest a decade ago. Meanwhile, young families double up in cramped apartments, first-time buyers are priced out of the communities where they grew up, and school enrollment data tells the story of whole neighborhoods closed off to the people who would benefit from access to what they offer.
It’s a problem made worse by our tax code, but it’s one that the tax code can help correct.
Based on estimates of homeowner equity, millions of homes have appreciated enough to exceed the federal capital gains exclusion for primary residences. The law allows a single filer to exclude from taxes up to $250,000 in gains from the sale of a principal residence; a married couple filing jointly can pocket up to $500,000 tax-free. In some states, as many as 40 percent of homes have gained enough value to exceed the cap. This “looming” tax bill discourages homeowners who might otherwise consider selling.
For homeowners who pass away, tax law allows their heirs to inherit the home free of any previous capital gains should they resell it. Instead of having to pay capital gains on years or even decades worth of appreciation, the home’s baseline value is reset to the current market value under a rule called step-up basis. This reset encourages some homeowners to hold onto their homes for life, even if they no longer live in it, as a tax mitigation strategy.
No single change to these laws would be a cure-all for the nation’s housing mismatch. But by addressing the problem from different directions, first by increasing the primary residence exclusion for capital gains then by modifying inheritance rules to close a costly loophole, they could rebalance the incentives that are keeping single-family homes locked away from growing families. And together they would do so at a lower fiscal cost to the government compared to implementing capital gains reform on its own, according to a recent report by The Budget Lab at Yale.
Tax-free appreciation, to a point
The primary-residence capital gains exclusion — Section 121 of the Internal Revenue Code — is one of the most widely used benefits in the tax code. To qualify, the seller must have owned and used the home as their main residence for at least two of the five years before the sale.
Congress created the exclusion in 1997, when the median home sold for $145,000. At the time, a $500,000 exclusion for joint filers covered more than three times the typical home’s value. But Congress hasn’t adjusted the thresholds since then, not even for inflation. In high-cost metro areas such as Boston, Denver, Seattle, and much of California, homes purchased for around $200,000 in the 1990s routinely sell today for well over $1 million. If the capital gains exclusion had been indexed to inflation since 1997, the exclusion would be over $500,000 for single filers and $1 million for joint filers in 2026.
In the early 2000s, fewer than 40,000 home sales per year — roughly 1.3 percent of all existing home transactions — generated gains exceeding the $500,000 joint exclusion. By 2022, that number surpassed 230,000, or 8 percent of all sales. In California, more than one in four existing home sales generate gains above the $500,000 threshold.
The National Association of Realtors estimates that some 8 million homeowners — 10 percent of the total — are sitting on gains large enough to top the exclusion for married joint filers if they sold today. Another 29 million homeowners — 34 percent of the total — would exceed the $250,000 single-filer exclusion. This group includes those who have held their home for more than two years after the death of their spouse.
Inheriting a windfall
For most homeowners, the capital gains thresholds remain more than adequate. The vast majority of households would owe no federal capital gains tax on a home sale under current law. The policy problem lies in the remaining 5 percent to 10 percent of homesellers. And it’s made worse by a feature of the tax code that discourages people from selling homes and other appreciated assets during their lifetimes.
Under the law, when a homeowner passes away, the tax basis of their estate, including their home, is “stepped up” to the current fair market value as of that date. This means that all appreciation accumulated during the owner’s lifetime disappears from the tax ledger. For example, an elderly widow owns a home in San Francisco that has gained $500,000 in value since she bought it with her spouse in 1980, after exhausting the $250,000 exclusion she would owe capital gains taxes on the remaining $250,000 gain under current law. But if she passes the house on to her children as an inheritance and they put it up for sale, they’ll be taxed only on the gains from the date they took ownership, which if they’re able to sell quickly would be minimal.
For a homeowner with significant appreciation, the optimal tax strategy is often to do nothing: stay in the home; enjoy the property tax protections that many states provide to long-term owners, especially those with low incomes; and pass the asset to their heirs so they can take advantage of the tax-free windfall thanks to the basis reset. The federal capital gains tax is essentially optional under this strategy.
Don’t just do something, stay there
Other barriers to moving reinforce the decision to stay rather than sell. State-level property tax caps, for example — California’s Proposition 13 is the most notorious — can lock longtime homeowners into property assessments substantially below current values. Selling would mean resetting the home to market rates and having to pay thousands more per year if the benefit can’t be transferred to a new property.
Add in the emotional weight of leaving a longtime family home, the difficulty of finding suitable alternative housing in a tight market, and the logistical burden of moving after decades in one place and it’s clear why tax incentives alone may not induce every retiree to sell a home that’s bigger than they need and beyond their willingness or ability to maintain.
2 reforms that work together
Still, the most direct federal tax barrier for a homeowner considering a sale is the capital gains tax on appreciation above the Section 121 thresholds. The bipartisan More Homes on the Market Act (MHOTMA), introduced in the House by Rep. Jimmy Panetta (D–Calif.) would address this by doubling the capital gains exclusion to $500,000 for single filers and $1,000,000 for married couples. It would also index both figures to inflation going forward. The bill’s more than 145 co-sponsors as of this writing reflect its bipartisan, geographically diverse appeal.
The bill would ease the tax exposure for gains beyond the current exclusion caps. For a couple who bought their home in 1995 for $250,000 and who could sell it today for $1.1 million, current law bill would impose capital gains tax on up to $350,000 in appreciation beyond the cap and yield a federal tax bill of $70,000 to $133,000 on the sale, depending on the sellers’ other income. Under the MHOTMA’s increased exclusion, their taxable gain would be contained within the cap. In that way, the measure would substantially reduce the incentive to stay put rather than move to a home more aligned with their family size.
By itself, rather than alongside a change in inheritance rules, there’s only so much a higher capital gains exemption can do for loosening up the housing market. Even doubling the exclusion wouldn’t close the stepped-up basis loophole. As long as the existing stepped-up basis rule for inherited property remains available, the best tax strategy for a homeowner with massive appreciation is still to hold the property for the rest of their life, then let their heirs collect the windfall tax-free.
Loosening the inheritance ties that bind
One way to address the inheritance issue entails modifying the inheritance rules to apply carryover basis for real property. Carryover Basis is the combination of the owner’s purchase price of the home plus the costs of improvements and major repairs made over time. Under carryover basis, heirs would inherit the previous tax basis along with the property. The gain accumulated over the owner’s lifetime would eventually be taxable when or if the heir sells the property. Under this rule, the option to avoid capital gains by holding a property for life would disappear, and with it the policy distortion that keeps homes off the market longer than they otherwise would be.
Nor would carryover basis harm people who intend to keep a house they inherited. Under the carryover basis rule, they wouldn’t realize the increase in value over the previous owner’s basis, and therefore wouldn’t have a tax bill unless and until they decided to sell.
Capital gains and basis reforms would be complementary. The doubled capital gains exclusion would make it easier to sell a primary residence, and carryover basis would close the door on a tax avoidance strategy that makes holding an underused property until death the rational financial decision. Together, the two policies pull on the same lever to liberate existing housing supply.
The revenue picture: A partial offset
The fiscal case for pairing these two policies is as important as the behavioral one. Doubling the Section 121 exclusion by itself would cost the federal government $76 billion in lost tax revenue over 10 years, according to the Budget Lab at Yale. It is likely this change would be concentrated in high-appreciation markets, and the benefit would flow primarily to older and wealthier homeowners with significant appreciation.
Carryover basis reform’s fiscal impact flows in the opposite direction. The Budget Lab estimates that applying carryover basis rules to inherited residential real estate would reduce lost revenue by $40 billion over 10 years, offsetting more than half the cost of the proposed doubling of the capital gains exclusion. Expanding the rule to all inherited real estate would bring in even more revenue, offsetting all but $20 billion of the $76 billion in lost revenue.
The distributional impact also would improve from combining the policies. The stepped-up basis benefit is among the more regressive features of the federal tax code. The Congressional Budget Office has estimated that nearly two-thirds of its value goes to the top income quintile, with more than one-fifth going to the top 1 percent. Modifying inheritance laws would shift the tax burden from middle-class homeowners who usually fall well within the current capital gains exclusion toward households with extraordinary real estate appreciation beyond even the raised exclusion.
If Congress wanted to more fully offset lost revenue from the capital gains exclusion, it could add additional asset classes to the carryover basis rule change. According to the Budget Lab, expanding carryover basis to all inherited assets would bring in enough revenue to eliminate capital gains taxes on primary residence sales and reduce the overall deficit by $114 billion over 10 years.
Better together
What combining capital gains and inheritance reform together can do is reduce the federal tax incentives that encourage wealthy homeowners to sit on large, underoccupied homes rather than sell them to growing families. Tens of millions of homeowners hold gains large enough that the step-up in basis rule represents a meaningful estate planning tool. Moving even a fraction of those owners toward selling sooner would add inventory to a market that desperately needs it.
Enacting both policies simultaneously is important because the combination is more effective than either piece alone. Doubling the exclusion would make it easier to sell long-held homes with significant appreciation, but it is a substantial tax expenditure. Applying carryover basis removes the incentive to hold real estate until death and generates new revenue to offset the expanded capital gains exclusion. Together, these policies form a package that could minimize a distortion in the housing market, partially pay for itself, and concentrate the modest cost of reform on those most able to bear it.
