BILL ANALYSIS
SB 1055
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Date of Hearing: May 12, 2008
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
SB 1055 (Machado) - As Amended: April 22, 2008
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Personal income tax: cancellation of indebtedness:
mortgage forgiveness debt relief
SUMMARY : Allows a solvent taxpayer to exclude from his/her
gross income an amount of qualified principal residence
indebtedness discharged by the lender, which is in conformity
with the federal Mortgage Forgiveness Debt Relief Act (Act) of
2007. Specifically, this bill :
1)Conforms the Personal Income Tax (PIT) Law to the federal Act
of 2007 (Public Law 110-142) by allowing an income exclusion
of cancellation of indebtedness income generated from the
discharge of qualified principal residence indebtedness.
2)Limits the amount of the cancellation of indebtedness income
eligible for the exclusion as follows:
a) One million dollars ($1 million) in the case of a
taxpayer filing single or as a head of household, and in
the case of married couples filing jointly.
b) Five hundred thousand dollars ($500,000) in the case of
a married taxpayer filing separately.
3)Applies to discharges occurring on and after January 1, 2007,
and before January 1, 2009.
4)Provides that no penalties or interest may be assessed on the
cancellation of indebtedness income eligible for exclusion if
that income resulted from the discharge of qualified residence
indebtedness during the 2007 taxable year.
5)Takes effect immediately as a tax levy.
EXISTING FEDERAL LAW :
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1)Includes in gross income of a taxpayer an amount of debt that
is discharged by the lender (known as 'cancellation of debt'
or COD), except for any of the following debts:
a) Debts discharged in bankruptcy;
b) Some or all of the discharged debts of an insolvent
taxpayer. A taxpayer is insolvent when the amount of the
taxpayer's total debts exceeds the fair market value of the
taxpayer's total assets;
c) Certain farm debts and student loans; or,
d) Debt discharge resulting from a non-recourse loan in
foreclosure. A non-recourse loan is a loan for which the
lender's only remedy in case of default is to repossess the
property being financed or used as collateral.
2)Requires a taxpayer to reduce certain tax attributes by the
amount of the discharged indebtedness in the case where that
indebtedness is excluded from the taxpayer's gross income.
3)Excludes from the gross income of a taxpayer any COD income
that resulted from a discharge of qualified principal
residence indebtedness occurring on or after January 1, 2007,
and before January 1, 2010.
4)Defines "qualified principal residence indebtedness" as
acquisition indebtedness within the meaning of Internal
Revenue Code Section 163(h)(3)(B), which generally means
indebtedness incurred in the acquisition, construction, or
substantial improvement of the principal residence of the
individual and secured by the residence. "Qualified principal
residence indebtedness" also includes refinancing of such debt
to the extent that the amount of the refinancing does not
exceed the amount of the indebtedness being refinanced.
5)Allows married taxpayers to exclude from gross income up to $2
million in qualified principal residence indebtedness and
married persons filing separately or single taxpayers may
exclude up to $1 million of the amount of that indebtedness.
For all taxpayers, the amount of discharge of indebtedness
generally is equal to the difference between the adjusted
issue price of the debt being cancelled and the amount used to
satisfy the debt. For example, if a creditor forecloses on a
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home owned by a solvent taxpayer and sells if for $180,000 but
the house was subject to a $200,000 mortgage debt, then the
taxpayer would have $20,000 of income from the cancellation of
the debt.
6)Excludes from tax a gain from the sale or exchange of the
taxpayer's principal residence if, during the five-year period
ending on the date of the sale or exchange, the property has
been owned and used by the taxpayer as his/her principal
residence for periods aggregating two years or more. An
amount of gain eligible for the exclusion is $250,000
(taxpayers filing single) or a $500,000 (for married taxpayers
filing a joint return).
EXISTING STATE LAW:
1)Conforms to the federal income tax law relating to the
inclusion of COD income in the taxpayer's gross income.
2)Requires individual taxpayers to pay their estimated
California income tax in four installments over the taxable
year.
3)Imposes a penalty for the underpayment of estimated tax, which
is the difference between the amount of tax shown on the
return for the taxable year and the amount of estimated tax
paid. Thus, any taxpayer who filed a 2007 PIT return on or
before April 15, 2008, was required to include any COD income
in his/her gross income, and are subject to the
underpayment-of-estimated-tax penalty if they failed to
include and pay tax on that COD income.
4)Waives the underpayment of estimated tax penalty if the tax
liability is less than $200, if there was not tax liability in
the prior taxable year, or total withholding plus estimated
tax payments total 90% of the tax shown on the current year
return or 100% of the tax shown on the prior year's return.
FISCAL EFFECT : The Franchise Tax Board estimates that this bill
will result in an annual revenue loss of $4.6 million in the
fiscal year (FY) 2007-08, $6.9 million in FY 2008-09, and $1
million in FY 2009-10
PROPOSITION 98 FISCAL EFFECT : Committee staff estimates that
this bill will result in a reduction in K-14 funding of $2.8
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million in FY 2008-09 and $400,000 in FY 2009-10.
COMMENTS :
1)The author states that, "SB 1055 is one part of a multi-part
solution to address California's mortgage problem. Under
existing California law, if a lender agrees to forgive some
portion of a borrower's mortgage debt, that forgiven debt is
taxed as ordinary income in the year in which the debt is
forgiven. Three common situations in which lenders forgive
debt are foreclosures on refinanced mortgages, short sales,
and short payoffs. In all three of these situations,
borrowers are upside down in their mortgages and unable to
afford to remain in their homes. The last thing we should do
to a borrower who has just lost his or her home is hit then
with a higher tax bill. The sooner this bill is enacted, the
sooner we can offer some needed relief to some of our troubled
borrowers." The author also states that, in recognition of
the state's significant budget shortfall, this bill will only
be effective for debt forgiven in 2007 or 2008, and will only
apply to debt forgiven on owner-occupied homes. Real estate
speculators would not be eligible for this bill's favorable
tax treatment.
2)The proponents of this bill state that the prospect of
taxation of "phantom" income acts as a substantial
disincentive to short sales and this bill is important because
it addresses a significant impediment for homeowners seeking
viable alternatives to foreclosure. The proponents also note
that the safe harbor provided by this bill is limited in
scope, since it applies only to debt forgiven during the years
2007-2008, and that such targeted relief makes sense from the
perspective of both basic fairness and protection of the real
estate business climate. The proponents contend that the
impact of this bill on middle class families is particularly
profound. Finally, the proponents argue that, from a
California tax policy perspective, conformity provisions that
provide fairness and simplification should take precedence
over any underlying revenue impact of this bill.
3)Committee staff notes:
a) While the idea of taxing COD income is counterintuitive
to most people, the economic theory behind existing law is
sound tax policy in that it reflects the fact that a
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person's net worth is increased if his/her debt is
cancelled. Under existing law, a loan amount is not
includible in the borrower's gross income; however, when
the borrower repays the loan, no deduction is allowed to
the borrower for the repayment of the principal amount of
the loan. In other words, because the borrower repays with
after-tax dollars, the amount of repayment is effectively
taxed in the year of repayment. If income is defined as a
change in a person's net worth, then, by definition, a
forgiven loan is income because a cancelled debt reduces a
taxpayer's liabilities, and thus, increases his/her net
worth. As noted by Debora A. Greier, a Professor of Law of
Cleveland State University, in her statement before the
United States Senate Committee on Finance, without this tax
rule to account for the forgiveness and non-repayment of
the loan, "the borrower will have received permanently
tax-free cash in the year of original receipt," i.e. the
year in which the borrower received the loan.
Existing law, however, provides several exceptions to the
general rule. Thus, a taxpayer may exclude COD income from
his/her gross income if the debt is discharged in Title 11
bankruptcy. If the debt is not discharged in bankruptcy,
the taxpayer may exclude the COD income if he/she is
insolvent, i.e. the taxpayer's liabilities exceed the fair
market value of his/her assets, determined immediately
prior to discharge. Both exceptions, however, are, in
essence, deferral provisions because they require a
taxpayer to reduce certain beneficial tax attributes,
including the taxpayer's basis in property, that would
otherwise decrease the taxpayer's income or tax liability
in future years. Other exceptions include COD income
generated by a cancellation of non-recourse debt and a
cancellation of debt that was intended to be a gift or was
the result of a disputed debt. A non-recourse loan is a
loan for which the lender's only remedy in the case of
default is to repossess the property being financed or used
as collateral. That is to say that the borrower is not
personally liable for the debt and the lender cannot pursue
the homeowner personally in the case of default.
b) In California, indebtedness incurred in purchasing a
home is deemed to be non-recourse debt (Code of Civil
Procedure Section 580b), and thus, generally, first
mortgages are considered to be non-recourse debt. However,
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even a taxpayer with non-recourse debt must pay tax on the
COD income realized from a reduction of that debt, or part
thereof, when a lender agrees to decrease the amount of the
original debt to reflect the current value of the property
secured by the debt, because a cancellation of non-recourse
debt without a transfer of the property creates COD income
for the taxpayer. Consequently, this bill would provide
relief to a solvent California homeowner who refinanced the
first mortgage or took out a home equity loan or a home
equity line of credit. It will also provide relief to a
solvent homeowner who benefited from a reduction of his/her
outstanding debt in a "workout" situation with the lender
where the homeowner retained the ownership of the home and
the lender, instead of foreclosing on the home, reduced the
outstanding debt to reflect the home's current value.
c) Thus, this bill applies to COD income realized by the
taxpayer from the cancellation of indebtedness as long as
the discharged debt was secured by a personal residence and
was incurred to acquire, construct, or substantially
improve the home, as well as debt that was used to
refinance such debt. Debt on second homes, rental
property, business property, credit cards, or car loans
does not qualify for the tax-relief provision. This bill
further limits the tax relief only to COD income that is
realized on or after January 1, 2007 and before January 1,
2009, with respect to the taxpayer's primary residence, to
the extent of $1 million ($500,000 in the case of a married
taxpayer filing separately).
d) Because this bill applies to solvent taxpayers, the
question arises as to whether the solvent taxpayer deserves
the tax relief that is usually afforded only to insolvent
taxpayers. As outlined by Debora A. Greier in her
statement before the United States Senate Committee on
Finance, existing tax law treats personal residences as
personal use assets providing personal consumption, and
therefore, personal residences are not depreciable and
losses on sale of those properties are not deductible. In
fact, tax law "assumes that any loss in value of a personal
residence is due to personal consumption rather than market
forces unrelated to the taxpayer's consumption." However,
it appears that currently, because of the unusual housing
market conditions, in many cases, the loss in value of a
personal residence is attributable to market conditions,
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similar to investment property, and not due to any personal
consumption of the taxpayer. Consequently, Debora A.
Greier concludes that the only way for tax law to measure
properly this taxpayer's wealth is to exclude COD income
from the taxpayer's gross income, provided that the
exclusion is a temporary measure necessary to address the
unusual market conditions.
e) From a public policy perspective, a rationale given for
excluding canceled mortgage debt income has focused on
minimizing hardship for households in distress and ensuring
that homeownership retention efforts are not thwarted by
tax policy. Some argue that the exclusion of canceled
residential debt income is necessary to prevent unintended
adverse consequences resulting from foreclosure prevention
efforts, especially, as lenders are being encouraged to
write-down, or work out, loans with distressed borrowers.
Another stated purpose is to prevent a reduction of
consumer spending by already financially distressed
households in the wake of foreclosures and housing market
disruptions. [See, e.g. Congressional Research Service's
report (CRS report) entitled 'Analysis of the Proposed Tax
Exclusion for Cancelled Mortgage Debt Income', dated
January 8, 2008, p. 10]. The opponents of the COD
exclusion argue that it may make debt forgiveness more
attractive for homeowners relative to the current tax law
and may encourage homeowners to be less responsible about
fulfilling their debt obligations.
f) This bill applies to any debt that is secured by the
principal residence and used to acquire, construct, or
improve any qualified residence of the taxpayer. The
definition of qualified principal residence indebtedness
includes second mortgages, home equity loans, and home
equity lines of credit used to improve the residence. Yet,
home equity lines of credit could have also been used to
finance consumption. This bill provides a financial
incentive for taxpayers to claim the COD income exclusion
for secondary loans even if the proceeds of those loans
were used for personal consumption.
4)While Committee staff appreciates both the tax and public
policy objectives advanced for the enactment of the federal
Act of 2007, the staff questions the amount of cancelled debt
that is eligible for the exclusion allowed by this bill.
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Specifically:
a) The proposed $1 million limitation on the amount of COD
income eligible for exclusion is much more than all but the
most affluent homeowners need in hardship assistance from
the state. According to DataQuick Information Systems, a
research firm, the median home price in California was
$358,000 in March of 2008, down from $484,000 in March
2007, when the market peaked, and the median home price in
California plunged 26% in March from a year earlier. Even
assuming the highest median price of a house in Marin
County - $775,000 - the 26% decrease in value of that house
translates into $201,000 of potential COD income, well
below the proposed COD exclusion of $2 million. Arguably,
the $201,000 amount reasonably represents a potential
amount of COD income that would be realized by the
homeowner of a house in Marin who either has found a buyer
willing to pay less than the original loan amount in a
"short sale" (a sale where the lender agrees to accept a
loss in the principal amount to be repaid in order to
approve the sale) or convinced the lender to forgive part
of the principal amount of the loan on that house. Given
that the median price of a house in most counties is even
lower than $775,000, what is the rationale for allowing a
taxpayer to exclude from his/her gross income $1 million of
COD income?
b) The proposed exclusion of COD income disproportionately
benefits taxpayers in higher tax brackets because the
"value" of an exclusion varies with the marginal tax rate
(or tax bracket) of the taxpayer. Thus, when a taxpayer,
who is in the 30% tax bracket, excludes $100 of COD income,
his/her tax is reduced by $30. On the other hand, if the
taxpayer is in a 20% bracket, $100 of COD income excluded
from his/her gross income would reduce his/her tax
liability only by $20. Because of the progressive rate
structure of our tax system, taxpayers in higher tax
brackets benefit more from income exclusions than
individuals in lower tax brackets. As stated in the CRS
report, this effect would be magnified if homeownership is
more concentrated among upper income individuals. Thus,
"the higher income taxpayer, with presumably greater
ability to pay taxes, receives a greater tax benefit than
the lower income taxpayer." (CRS report, p. 8).
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c) This bill, in conformity with the federal tax law,
allows the proposed COD income exclusion for qualified
principal residence indebtedness discharged by the lender.
A taxpayer's home is considered to be his/her principal
residence if the taxpayer owned and resided in that home
for at least two of the previous five years. It appears,
therefore, that a taxpayer may claim an exclusion of COD
income twice , to the extent that he/she can establish that
he/she has had two principal residences in the last five
years.
d) Existing law already heavily subsidizes owner-occupied
housing, even without a COD income inclusion, by allowing a
deduction for mortgage interest and state and local real
estate taxes, and excluding up to $500,000/$250,000 of gain
on the sale of a principal residence. In fact, according
to the CRS report, some analysts argue that this
preferential tax treatment encourages households to
over-invest in housing and not in business investments that
might contribute more to the nation's productivity and
output.
e) Generally, tax expenditures are enacted to provide
certain relief, affect taxpayers' behavior, influence
business practices and decisions, or achieve social goals.
This bill benefits taxpayers pursuing short sales,
refinancing, mortgage modifications, or mortgage
forgiveness. However, given that 9.3% is California's
highest effective rate of personal income tax (as compares
to 35% under the federal income tax law), it is unlikely
that a change in the state income tax laws would
significantly impact taxpayers' decisions. Thus, this bill
provides tax relief to taxpayers who would not have acted
differently, regardless of this measure.
f) Some analysts argue that millions of dollars in
mortgages were granted to marginal home buyers at extremely
low initial interest rates and that those mortgages were
aggressively marketed to unsophisticated buyers. Is a
buyer of a multimillion dollar house as unsophisticated as
a first home buyer of a more modest house? Presumably,
people who buy expensive homes have some knowledge of
lending procedures and practices, if not professional help.
Generally, the amount of household income is correlated
with foreclosure, in that those with lower income are
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experiencing more financial hardship. If the policy
rationale for the enactment of this bill is to minimize
hardship for households in distress, then the Committee may
wish to consider whether the proposed limits of $1
million/$500,000 for the COD income exclusion are
appropriate and whether those limits should be adjusted to
provide relief only to those households that are in need of
state assistance. The Committee may wish to limit the
application of this bill only to households with low and
moderate incomes. Alternatively, the Committee may wish to
amend the bill to allow an exclusion from gross income only
for a percentage of the taxpayer's COD income (possibly,
measured by a decrease in the highest median price of a
house in the county where the house is located) in the year
in which that income is realized and defer a deduction of
the remaining amount to future taxable years.
5)Committee staff notes that some analysts anticipate a new wave
of mortgage interest-rate resets in 2009, including resets in
prime loans given to people with good credit.
6)Committee staff notes that AB 1918 (Niello), introduced in the
current legislative session, amends the PIT Law to conform to
the federal Act of 2007, except that a taxpayer may exclude up
to $2 million ($1 million in the case of a married individual
filing separately) of cancelled debt, provided that the debt
was cancelled prior to January 1, 2010, instead of January 1,
2009. AB 1918 is set to be heard in this committee today.
REGISTERED SUPPORT / OPPOSITION :
Support
California Association of Realtors
Center for Responsible Lending
City of Sacramento
California Bankers Association
The California Chamber of Commerce
The Greenlining Institute
Spidell Publishing, Inc
California Credit Union League
Opposition
None on file
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Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098