BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Jenny Oropeza, Chair
SB 1055 - Machado
Introduced: January 7, 2008
Hearing: February 13, 2008 Tax Levy Fiscal: Yes
SUMMARY: Changes California Income Tax Law to conform with
the Mortgage Debt Relief Act of 2007
EXISTING FEDERAL LAW provides that cancellation of
debt income, also known as discharge of indebtedness, is
generally included in gross income, except for:
Debts discharged in bankruptcy
When the taxpayer is insolvent, debt
discharge is excluded up to the amount of the
insolvency, but triggers specified basis
adjustments
Certain farm debts, and
Debt discharge resulting from a
non-recourse loan in foreclosure. A loan is
non-recourse when the lender's only recourse
against the borrower is to repossess the asset.
EXISTING FEDERAL LAW, the Mortgage Forgiveness Debt
Relief Act of 2007 (P.L. 110-142), signed by the President
on December 20, 2007, provides that taxpayers may exclude
qualified principal residence indebtedness discharged after
January 1, 2007 but before January 1, 2010. Married
taxpayers may exclude up to $2 million in qualified
SB 1055 - Machado Page 5
principal residence indebtedness, while married persons
filing separate or single persons may exclude up to $1
million. Taxpayers may only exclude cancellation of debt
income for principal residences, which federal law limits
to the residence the taxpayer owns and uses as their
principal residence for two out of the last five years.
EXISTING STATE LAW conforms to federal tax statutes
guiding cancellation of debt income.
THIS BILL conforms state law to the Mortgage Debt
Relief Act, except taxpayer may only exclude debt cancelled
before January 1, 2009 instead of January 1, 2010.
FISCAL EFFECT:
For the provisions conforming only to excluding
cancellation of debt income, Franchise Tax Board (FTB)
estimates revenue losses of $5 million in 2007-08, $7
million in 2008-09, and $1 million in 2009-10.
COMMENTS:
1. Author's Statement
According to the Author, "Under existing state law,
mortgage debt that is forgiven by a lender is taxable to
the borrower as ordinary income in the year in which the
debt is forgiven. Unfortunately, in today's depressed
housing market, many borrowers have found themselves upside
down in their mortgages, owing more to their lenders than
their homes are worth. A sizeable number of these
borrowers also find themselves unable to afford their
mortgage payments, due in part to over exuberant lending by
the financial institutions which originated their
mortgages. Mortgage lenders and servicers are increasingly
offering to work with borrowers to help them avoid
SB 1055 - Machado Page 5
foreclosure. SB 1055 will allow borrowers whose lenders
agree to forgive some or all of their mortgage debt to
exclude that forgiven debt from their income for state tax
purposes. SB 1055 will help borrowers whose lenders agree
to a short sale, a short payoff, a loan modification, or a
loan refinance in which some or all of the borrower's
original debt obligation is forgiven. Existing state tax
law, which taxes forgiven mortgage debt, can be a heavy
burden for borrowers already having trouble meeting their
financial obligations.
The federal government has already enacted tax relief
of the type proposed by this bill. In recognition of the
state's significant budget shortfall, SB 1055 will only be
effective for debt forgiven in 2007 or 2008, and will only
apply to debt forgiven on owner-occupied homes (i.e., real
estate speculators will not be eligible for the favorable
tax treatment)."
2. A Touch Too Much?
SB 1055 benefits California taxpayers who receive
mortgage forgiveness; however, because the measure conforms
to federal changes, taxpayers will receive more benefits as
their incomes and amount of cancelled debt rise. First,
the income exclusion equals the amount of cancelled debt,
which will likely be higher for more valuable homes.
Second, income exclusions generally benefit taxpayers in
higher income brackets but the impact in California is
tempered assuming that most taxpayers affected pay tax at
the 9.3% rate which applies to all taxpayers with adjusted
gross incomes between $43,814 (single or married/registered
domestic partner filing separate) or $89,628 (married
filing joint) and $1 million, when the 1% mental health
surcharge applies, regardless of the amount of cancelled
debt. Third, SB 1055 conforms to the recently enacted caps
on cancelled debt for principal residence indebtedness: $2
million in cancelled debt income for married filing joint
and $1 million for all other filers. The Committee may
wish to consider whether the caps provide more cancelled
debt forgiveness than all but the most affluent taxpayers
need -and consider amending the measure to cap the
cancelled debt income exclusion to the current $500,000 and
SB 1055 - Machado Page 5
$1 million caps for the mortgage interest deduction.
The author has agreed to amend the current version of
the bill and reduce the cap from $2 million (joint), $1
million (single) to $1 million (joint), $500,000 (single).
The FTB estimates $200,000 less in revenue loss per
year resulting from this amendment.
3. To Err is Human, To Forgive Divine
According to several experts, the current mortgage
problem has many causes: lenders departing from historic
credit standards, underwriters and investors incorrectly
pricing risk, low interest rates, and mortgage products
predicated upon ever-rising home prices and infinite
refinancing opportunities. Many Californians now see the
fair market values of their homes falling well below the
amounts of their loan values with little sign of a bottom
ahead. Combined with declining values, many Californians
face escalating mortgage payments due to readjustments
contained in the current vintage of mortgages, which
promised low rates followed by much higher payments at the
end of the introductory period. Some homeowners have
sufficient income and home value to refinance, while others
who are unable to refinance may only be able to find buyers
willing to pay less than the original loan amount, dubbed a
"short-sale," where the lender must agree to accept a loss
in the principal amount to be repaid in order to approve
the sale. Others may be able to convince their lenders to
forgive part of the principal amount of the loan, although
lenders have primarily changed only interest rates, thereby
mitigating the readjustments, up to this point. Because
federal law has always considered cancelled debt includible
in gross income, Congress approved and the President signed
the Mortgage Forgiveness Debt Relief Act of 2007, which
excludes cancelled debt income from income to help
homeowners facing this hardship, many of whom live in
California.
The economic theory supporting the recent federal tax
SB 1055 - Machado Page 5
law change reflects the unique nature of the asset and the
problem. According to Tax Law Professor Debora A. Greier
of Cleveland State University, income tax law treats houses
as personal use assets providing personal consumption -
they are not depreciable, and losses are not deductible,
much different from stocks<1>. Greier states that current
income tax law assumes that any loss in a home's value is
due to personal consumption, such as not maintaining the
home and causing it to lose value, much like a car loses
value as a taxpayer consumes as he or she drives a car<2>.
However, Greier concludes that excluding cancelled debt
income in this case makes sense because larger market
forces cause the loss and affect all homes, and tax law
should consider the loss in the same way as non
personal-use items<3>. Greier adds that the sunset clause
in the federal changes is consistent with the temporary
nature of this market correction<4>.
4. The Phantom of the Opera
Including cancelled debt in gross income may be
intuitive to tax specialists, but has recently been
referred to as "phantom income." Considering cancelled
debt income is a long-standing tenet of federal tax law and
sound public policy. Taxpayers do not include borrowed
funds in income in the year received because of the
obligation to repay the loan - his or her financial status
is unchanged because the loan must be repaid. When lenders
reduce the principal amount on a loan, the taxpayer
realizes a gain in his or her financial situation because
some loan proceeds not previously gained taxed need not be
repaid. In U.S .v. Kirby Lumber Co., 284 US 1 (1931) the
---------------------
<1> Statement of Deborah. A Greier before the United States
Senate Committee on Finance, P. 7
<2> Ibid, P. 8
<3> Ibid.
<4> Ibid.
SB 1055 - Machado Page 5
Court held that a company that had issued $12 million in
bonds and later repurchased some of them at $138,000 less
than their face amount made a clear gain of $138,000,
clarifying a previous holding that tied the tax status of
the cancelled debt to the net effect of the initial
investment (Bowers v. Kerbaugh Empire Co, 271 U.S. 170
(1926)). Congress codified that discharged indebtedness is
income in 1954 but left considerable discretion up to the
Court. Recent federal tax law changes that SB 1055
conforms to depart from this long-standing rule in tax law.
5. Will SB 1055 Change Behavior?
Policymakers generally intend tax expenditures to coax
taxpayers to enact in positive ways - either economically
or socially - so-called positive externalities. For
example, California provides research and development tax
credits to spur innovation that leads to increased
employment and economic activity as well as superior
consumer products. Some tax expenditures seek to provide
equity - sales tax exemptions for food and prescription
drugs intend to reduce the cost of needed goods and don't
seek to change any behavior.
While SB 1055 benefits taxpayers pursuing short sales
or mortgage forgiveness, few will change behavior. First,
the original lender loses money when forgiving debt; the
tax obligation of the borrower will not factor in to that
decision. Second, the taxpayer's first concern is escaping
from a troubling or impossible mortgage which is their
primary motivation for pursuing forgiveness of principal or
entering into a short sale. Third, before the recent
changes, federal tax law would deter a troubled homeowner
from pursuing a short sale or forgiveness, but given the
federal change, the marginal effect of the state tax
exclusion will be small. A seller with a $500,000 loan
that agrees to a $400,000 short sale, thereby incurring
$100,000 in cancelled debt income would have added $29,000
to their income at the 29% rate before the recent federal
change. The seller must pay only $9,300 in income taxes at
the top California marginal rate - a rather small amount
SB 1055 - Machado Page 5
compared to the relinquishment of a loan that exceeded fair
market value by $100,000 and the $29,000 in federal tax
forgiveness. While SB 1055 helps ease the hardship
taxpayers suffer because of rapidly declining home prices
combined with payment increases attributable to mortgage
products issued using faulty if not fantastic assumptions
and risk evaluations, the bill will likely result in a
benefit for taxpayers that would not have acted differently
regardless of this measure.
6. What About Second Mortgages and Home Equity Loans and
Lines of Credit?
The Mortgage Forgiveness Debt Relief Act uses existing
federal statutes that define eligibility to deduct
acquisition indebtedness, commonly known as the Mortgage
Interest Deduction, to qualify the income exclusion. This
definition provides that any debt both secured by the
residence and used to acquire, construct, or improve any
qualified residence of the taxpayer may be deducted.
Because SB 1055 conforms to this definition, taxpayers may
exclude cancelled debt income that meets that definition,
which would include second mortgages, home equity loans,
and home equity lines of credit used to improve the
residence. However, taxpayers may have significant
financial incentive to include cancelled debt income on
secondary loans where proceeds were spent on personal
consumption, and auditors may not detect these taxpayers
because audit resources would be more cost-effectively
deployed on taxpayers with larger tax liabilities.
Support and Opposition
Support:California Bankers Association
California Mortgage Bankers Association
California Association of Realtors (if amended)
SB 1055 - Machado Page 5
Spidell Publishing, Inc.
---------------------------------
Consultant: Colin Grinnell