How the Capital Gains Tax Locks Americans in Place
Recent Republican proposals to exempt capital gains on certain home sales are a useful reminder that the capital gains tax distorts economic decisions and harms Americans. The Republican Study Committee (RSC) recently proposed eliminating capital gains taxes on rental home sales to tenants and on home sales to first-time buyers. President Trump has repeatedly floated expanding the exclusion for capital gains on primary residences. These ideas are partial fixes for a much broader distortion in the tax code.
The capital gains tax encourages holding on to appreciated homes, discourages relocating or downsizing, and raises the after-tax cost of investing in the housing stock. However, these effects are not limited to housing. The economic distortions of the capital gains tax appear whenever an asset is expected to appreciate over time. Homes, businesses, land, stocks, precious metals, artwork, and cryptocurrencies all face the same basic penalty for being sold or exchanged after appreciation.
Rather than making new, sector-specific carveouts to the capital gains tax, Congress should lower the rate for all investments or, better yet, simply repeal the tax altogether.
Reduced Investment, Lock-In
The capital gains tax applies when an asset is sold for more than its purchase price. That gain is subject to federal income tax. Assets held for less than a year are taxed at ordinary income tax rates, which top out at 37 percent. Assets held for one year or more face a lower rate, with a top statutory rate of 20 percent plus a 3.8 percent net investment income tax, for a combined 23.8 percent, plus state income taxes.
The capital gains tax is a second layer of tax on income that was already taxed when it was earned. Consider a worker who earns wages over his career. Those wages are taxed through the income tax and payroll taxes before he ever sees the money. After paying those taxes, he spends some of his income immediately and saves what’s left. Eventually, he can buy a home.
Over the next thirty years, the house appreciates. Some of that increase reflects real improvements and higher demand. Some of it is simply inflation (yes, the government taxes inflationary gains). The rate of return on an asset is, in effect, what the market pays people to defer consumption, to save the money instead of spending it.
When he finally sells the home, the tax code treats the difference between the sale price and the original purchase price, plus any improvements, as a taxable capital gain. The more the government takes, the less saving is rewarded. Thus, instead of putting money into a home, a business, or the stock market, the capital gains tax gives workers a stronger incentive to spend the income when it is first earned. This depressive effect on investment slows broader measures of economic growth.
The lock-in effect also becomes stronger over time. Long-held assets tend to accumulate large nominal gains, and delaying realization can reduce effective tax rates. This is especially true for older owners whose assets will benefit from step-up in basis at death, which allows property to be inherited at its current market value, wiping away the capital gain, and allowing it to be sold with little or no tax.
The result is that owners of assets with large potential gains delay sales and avoid reallocating capital to more productive uses to avoid the tax. For example, a homeowner may stay in a house that no longer fits their family or job because selling would trigger a large tax bill. A landlord may hold onto a rental property rather than sell to a tenant or developer because the tax on the gain makes the transaction unattractive.
The Tax Code Acknowledges the Problem
The current tax code explicitly acknowledges the distortions caused by the capital gains tax through a patchwork of exceptions and workarounds. Some of these include:
- Lower capital gains tax rate on long-term gains. The lower 20 percent top rate is intended to reduce lock-in and lessen the investment disincentives caused by double taxation.
- Tax-advantaged savings accounts such as IRAs, 401(k)s, and 529s, which shield investment returns for retirement and education from the capital gains tax.
- Step-up in basis at death, which permanently eliminates capital gains taxes on inherited unrealized appreciation.
- Section 1031 like-kind exchanges, which allow certain real estate gains to be deferred when reinvesting proceeds into a similar (like-kind) property. The 2017 tax bill narrowed the scope of like-kind exchanges.
- Section 1202 exclusion for qualified small business stock, which reduces or eliminates capital gains taxes on investments in certain early-stage companies. The 2025 reconciliation bill expanded this treatment.
- $250,000 capital gains exclusion from the sale of a primary residence. $500,000 exclusion for a married couple filing jointly.
Each of these provisions has been added by lawmakers to reduce the distortions of the capital gains tax for specific industries or activities. They reduce lock-in, encourage investment, and avoid taxing illiquid gains. But each carveout also creates its own distortions through arbitrary line-drawing, which can result in tax planning rather than true new economic activity. Whenever special treatment is written into the tax code, economic decisions end up being shaped, in part, by the definitions rather than the economic fundamentals.
New Proposals, Same Diagnosis
The latest capital gains proposals fit into this pattern of tinkering around the edges rather than simply acknowledging the fundamental problems with the capital gains tax itself.
Expanding or creating new exclusions for gains on home sales may free up some existing housing stock so that retirees can more easily downsize and younger couples can access the space they need to raise families. Exempting gains when homes are sold to first-time buyers or tenants, as proposed by the RSC, would be a marginal step in this direction, albeit with unnecessary restrictions and significant administrative burdens. Fully eliminating capital gains taxes on owner-occupied housing, or better yet, all real estate investments, would go even further. This would eliminate the penalty on downsizing and could help expand access to larger homes in higher-priced neighborhoods, but it would also increase the relative tax preference for real estate over other assets.
Indexing capital gains for inflation would prevent the tax code from treating rising prices as real income. It would reduce effective tax rates and mitigate some lock-in effects. Indexing the capital gains tax also adds complexity and, without indexing other parts of the tax code, could create new tax planning opportunities.
Repealing the estate tax would remove yet another layer of taxation on unrealized gains. The estate and gift tax imposes a 40 percent tax, over the exemption threshold, on wealth transferred at death. Today, that tax functions in part as a backstop to the step-up in basis rules, which eliminate the capital gains tax on appreciated assets when they are inherited.
Eliminating the estate tax on its own could increase lock-in for affected estates by strengthening incentives to hold appreciated assets until death. For that reason, estate tax repeal should be paired with broader capital gains reform. The best option is to repeal the capital gains tax altogether. Another is to replace step-up basis with carryover basis, ensuring that gains are taxed once, and only once, whether they are realized before or after death. Either approach would eliminate forced asset sales, lower compliance and planning costs, and ease the burden on asset-rich families, farmers, and small business owners.
The Case for Eliminating the Capital Gains Tax
Each new exemption narrows, complicates, and makes the capital gains tax more economically distortionary for non-exempt activities. Preferences and exclusions can relieve specific distortions, but they also create new ones. They favor certain assets, transactions, and taxpayers over others. They complicate compliance and invite lobbying for special treatment. The cleanest solution is to remove the source of the distortion.
Eliminating the capital gains tax for all assets would be a meaningful improvement. A more structural reform, such as a flat consumption-income tax, would go further by taxing earnings when they are spent rather than when they are saved or invested. A tax system that does not layer additional taxes on investment returns would not need carve-outs for housing, inheritances, inflation, or retirement accounts. The growing list of capital gains exemptions and recent proposals to add new ones are signs that the system needs more fundamental reform.