California’s Housing Shortage Has a Washington Fingerprint

I landed in California in 1990, the tail end of the Reagan afterglow, when the state still felt like the reward at the end of the road trip. Three decades later I’ve got two sons who will be hunting for their first home in a state where “starter home” has become a punchline. What’s standing between them and a house isn’t just price. It’s their parents’ generation, sitting tight in homes we can’t afford to sell.

Blame Washington. Specifically, blame a tax rule Congress wrote in 1997 and then forgot existed.

Under Section 121 of the tax code, a homeowner can exclude up to $250,000 of capital gain on the sale of a primary residence from federal tax, or $500,000 for a married couple filing jointly, so long as they’ve owned and lived in the place for two of the last five years. Congress set those numbers in the Taxpayer Relief Act of 1997 and never touched them again. No inflation adjustment. No update for the fact that home values have exploded since Bill Clinton was in office. The same year Congress locked in that $500,000 ceiling, Titanic hit theaters and the Spice Girls owned the charts. My oldest son wasn’t even born yet. The exclusion is old enough to buy the house it’s punishing you for selling.

Here’s the mechanism, because it matters more than the outrage. Say a married couple bought a house in the late 1990s for $300,000, put $150,000 into it over the years in documented improvements, and sells it today for $1.6 million after $100,000 in selling costs. Their gain before any exclusion runs about $1.05 million. Subtract the $500,000 joint exclusion and they’re still on the hook for federal tax on roughly $550,000, on top of whatever California’s Franchise Tax Board takes, since the state taxes that gain as ordinary income up to 13.3%. That’s not a wealthy family who is cashing out a mega-mansion. That’s a couple who bought a normal 3 bed/2 bath house a long time ago and watched the market do what California’s housing shortage always does to prices.

New data from the real estate analytics firm Cotality bears this out. One in four California home sellers now realize more than $500,000 in gain when they sell, enough to exceed the exclusion before they’ve paid a single closing cost. That’s not a rounding error. That’s a quarter of the sellers in the largest housing market in the country running into a tax wall built for a very different economy.

The predictable result is what economists call the lock-in effect, and what I’d call common sense. If selling your house triggers a tax bill in the mid five figures or worse, you don’t sell. You stay put, your empty-nest four-bedroom stays off the market, and the young family that would have bought it goes looking somewhere else, usually somewhere less expensive and further from work. Inventory that should turn over every seven or eight years sits frozen for two decades. Multiply that by a few million homeowners and you’ve got a housing shortage that Sacramento didn’t cause but sure isn’t fixing either.

Congress actually has a fix sitting in committee, and it’s the rare bill that draws support from both sides of the aisle without anybody having to hold their nose. Rep. Jimmy Panetta, a California Democrat, and Rep. Mike Kelly, a Pennsylvania Republican, introduced the More Homes on the Market Act in the House back in February 2025. It would double the exclusion to $500,000 for single filers and $1 million for joint filers and then index both figures to inflation going forward so Congress never has to relive this fight. A Senate companion followed in December, led by Texas Republican John Cornyn with Colorado Democrat Michael Bennet, Montana Republican Steve Daines, California Democrat Adam Schiff, Wyoming Republican John Barrasso, and Arizona Democrat Mark Kelly signed on. Both bills remain stuck in their respective tax committees, which is where good ideas in Washington go to gather dust while Congress finds time for whatever’s trending.

To be fair, this isn’t a free lunch, and the critics raise a point worth taking seriously. Doubling the exclusion reduces federal revenue, and some will argue it mostly helps long-tenured owners who are already sitting on substantial equity. Fine. But “sitting on equity” and “having cash” are not the same thing, and a tax code that punishes you for turning illiquid home equity into a smaller house and a paid-off mortgage isn’t protecting anyone from anything. It’s just protecting the status quo, which in California’s housing market means protecting scarcity. And the fix doesn’t give anyone a windfall. It excludes gain, not sale proceeds, and taxable gain still starts with your sale price minus your costs and your adjusted basis. Keep your receipts for that kitchen remodel and that new roof. They count.

There was never a policy reason to freeze this number for thirty years. Congress just never got around to unfreezing it, the same way Congress never gets around to a lot of things that would actually help ordinary families instead of donors. A bill with sponsors from both parties, in both chambers, that costs Washington nothing to implement fairly and asks nothing of taxpayers except a fair shot at their own equity, should not need three decades to become law.

My kids don’t need Congress to hand them a house. They need the people who already own one to be able to sell it without Uncle Sam treating a Reagan-era tax bracket like scripture. Pass the More Homes on the Market Act, index it, and get out of the way. The market will do the rest, the way it always does when Washington stops standing in the way.