Though many industry groups, including the National Association of Realtors, reported last week that home sales are expected to remain strong in 2000 despite the recent run-up in interest rates, few observers acknowledged the seminal factor that contributed to this counterintuitive trend: the government's 1998 change in the capital gains tax framework for real estate.

As the Mortgage Bankers' Association of America's refi index and home purchase index continue to stay high despite these recent interest rate increases, real estate economists speak of economic growth and the wealth effect as possible reasons for a higher-than-expected level of housing turnover; but, more significantly than this, a change in the capital gains tax laws - particularly a 1997 enactment that stated that capital gains on a home are no longer taxable for the first $250,000 - has, by itself, given individuals an incentive to sell their home and buy a new one.

"It is very plausible that senior citizens and retirees would be more apt to sell their homes today and go into a rental in Florida or whatever, and housing turnover is certainly higher today, because [before the law] they may have maintained their home because of the huge capital gains tax that they would have had to pay," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "That tax would have cut down the benefit of selling your home, and today, that is not the case. Now, the velocity of housing turnover will be higher, because people do not have to deal with this tax."

And indeed, despite the fact that fixed mortgage rates are headed toward 8.5%, existing-home sales remain robust, and 2000 is still likely to be one of the best recent years on record for sales. "The market is due for a breather - the 5.18 million existing-home sales record we saw in 1999 is astounding, and any sales level remotely close to the five-million mark is extremely strong in historic terms," said Dr. James F. Smith, NAR's chief economist.

Tax May Skew

Prepayment Comparisons

This rather important factor of the capital gains tax law may also skew any comparisons that have recently been made between the current interest rate environment and that of pre-1997.

"This is where some Street analyses break down," noted Hoeh. "It's hard to compare 1999 turnover rates to, lets say, September 1996, when there were similar interest rates."

At least anecdotally, in late 1996 and early 1997, there were much lower prepayment rates on discount mortgages. Comparatively, however, this month's 6.5% securities sped up a little bit - an unusual occurrence given the interest rate environment - and the capital gains issue is one of the best explanations of why prepayment rates have remained so high.

"Basically, the law lowered the capital gains tax to zero on primary residences as long as you lived there for two years," added Dreyfus' Hoeh. "That's a $250,000 tax-free gain for an individual and a $500,000 gain for a married couple, so anybody who has lived in their homes for the last 20 years - the typical baby boomer who has raised their kids - had an enormous capital gains tax on their home; but after this law was put through, they are now more likely to sell their home, and put that money into Internet stocks and travel for the rest of their lives."

That was not the case five years ago. The prospect of paying a huge sum in order to sell your house and rent an apartment was not that appealing to baby boomers.

"There was, therefore, a lot of pent-up interest in getting rid of that tax before 1997," said one market source.

Now, people are selling like crazy. According to the NAR, builders are having difficulty keeping up with demand in many areas. The NAR projects total housing starts to drop 5.6% in 2000 to 1.58 million units. "New-home sales should drop 5.2% this year to 845,000 units, partially due to the lead time needed to start new housing projects," NAR's Smith noted. Additionally, the current residential market is a seller's market, Smith says, with the number of buyers surpassing sellers.

"This is keeping the turnover percentages really high," Hoeh added. "Additionally, a lot of people have made so much money in the stock market that it is starting to filter into demand for higher quality goods and higher price homes, and so housing starts remain high, and people are paying money on new homes."

Now, homeowners are very interested in trading up on their homes. Additionally, because of this embedded turnover activity that has come about as a result of the change in the capital gains tax laws, prepayments have been paying at higher-than-normal speeds.

"This is going to have huge ramifications for the mortgage market, and it will continue to fuel stronger housing demand," Hoeh said.

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