BILL ANALYSIS �
AB 42
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Date of Hearing: April 1, 2013
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 42 (Perea) - As Amended: March 4, 2013
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Taxation: cancellation of indebtedness: mortgage debt
forgiveness
SUMMARY : Extends for one additional taxable year, in modified
conformity to the recently enacted federal law, the tax relief
for income generated from the discharge of qualified principal
residence indebtedness (QPRI). Specifically, this bill :
1)Provides that Internal Revenue Code (IRC) Section 108,
relating to income from discharge of QPRI, as amended by
Section 202 of Federal American Taxpayer Relief Act (FATRA),
shall apply, except as otherwise specified.
2)Applies to discharge of QPRI occurring on or after January 1,
2013, and before January 1, 2014.
3)Takes effect immediately as a tax levy.
EXISTING FEDERAL LAW :
1)Includes in gross income of a taxpayer an amount of debt that
is discharged by the lender, except for any of the following:
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 debt exceeds the fair market value of the
taxpayer's total assets;
c) Certain farm debts and student loans; or,
d) Debt discharged 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. (IRC
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Section 108).
2)Requires a taxpayer to reduce certain tax attributes by the
amount of the discharged indebtedness in the case where the
indebtedness is excluded from the taxpayer's gross income.
(IRC Section 108)
3)Excludes from a taxpayer's gross income cancellation of
indebtedness (COD) income that resulted from the discharge of
QPRI occurring on or after January 1, 2007, and before January
1, 2014.
4)Defines "QPRI" as acquisition indebtedness within the meaning
of IRC 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. "QPRI" 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 QPRI (married persons filing separately 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 home owned
by a solvent taxpayer and sells it 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 COD.
6)Specifies that if, immediately before the discharge, only a
portion of a discharged indebtedness is QPRI, then the
exclusion applies only to so much of the amount discharged as
it exceeds the port of the debt that is not QPRI. For
example, a taxpayer's principal residence is secured by an
indebtedness of $1 million, of which only $800,000 is QPRI.
If the residence is sold for $700,000 and $300,000 debt is
forgiven by the lender, then only $100,000 of the COD income
may be excluded under IRC Section 108.
7)Defines the term "principal residence" pursuant to IRC Section
121 and the applicable regulations.
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8)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 year or more. The
amount of gain eligible for the exclusion is $250,000
(taxpayers filing single) or a $500,000 (for married taxpayers
filing a joint return).
9)Requires a taxpayer to reduce the basis in the principal
residence by the amount of the excluded COD income.
EXISTING STATE LAW :
1)Conforms to the federal income tax law relating to the
exclusion of the discharged QPRI from the taxpayer's gross
income, with the following modifications:
a) Applies to the discharge of indebtedness occurring on or
after January 1, 2007 and before January 1, 2013.
b) The maximum amount of QPRI is limited to $800,000
($400,000 for married/RDP filing separate).
c) For discharges occurring in 2007 or 2008, the total
amount of non-taxable COD income is limited to $250,000
($125,000 in the case of a married /RDP individual filing a
separate return).
d) For discharges occurring on or after January 1, 2009,
and before January 1, 2013, the maximum cancellation of
debt income exclusion is $500,000 ($250,000 for married/RDP
filing separate).
e) Requires individual taxpayers to pay their estimated
California income tax in four installments over the taxable
year. 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. However, no underpayment penalty or
interest is assessed for the 2009 tax year.
FISCAL EFFECT : The Franchise Tax Board (FTB) estimates an
annual revenue loss of $50 million in fiscal year (FY)
2013-2014, and $5 million in FY 2014-15.
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COMMENTS :
1)Author's Statement . The author provided the following
statement in support of this bill.
AB 42 would extend the tax relief on forgiveness of
mortgage debt by conforming California law to federal law.
A higher than average unemployment rate has persisted for
years and has left many Californians without the resources
to sustain their mortgages, while the mortgage crisis has
drove down home values and left many homeowners
'underwater' on their property investment. After
foreclosure, mortgage refinancing, or short sale of a home,
a bank can cancel or forgive thousands of dollars of an
individual's mortgage debt. Federal and State income tax
laws generally define cancelled debt as a form of income.
Without additional legislation to exclude cancelled debt,
many California may be taxed on "phantom" income they never
received.
2)Arguments in Support . Proponents of this bill state that AB
42 seeks to provide full conformity to the federal rules
relating to income from discharge of indebtedness in order to
grant additional tax relief to individuals who can least
afford a tax bill after losing their home.
3)Mortgage Debt Forgiveness: Background . In 2008, the
Legislature approved SB 1055 (Machado), Chapter 282, which
provided modified conformity to the Mortgage Forgiveness Debt
Relief Act (MFDRA) for discharge of mortgage indebtedness in
2007 and 2008 tax years. In 2010, the Legislature enacted SB
401 (Wolk), Chapter 14, to provide homeowners even greater
assistance. It not only extended the mortgage debt
forgiveness provision until January 1, 2013, but also
increased the amount of forgiven mortgage indebtedness
excludable from taxpayer's gross income from $250,000
($125,000 in case of married individual/RDP filing separate
return) to $500,000 ($250,000 in case of married
individual/RDP filing a separate return). On January 2, 2013,
the federal government enacted FATRA as part of the fiscal
cliff deal. FATRA extended the exclusion from gross income
for COD generated from the discharge of QPRI, as provided for
by the MFDRA, for one additional taxable year, beginning on or
after January 1, 2013.
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4)Why is COD Taxable ? Most individuals find the idea of taxing
debt cancellation counter intuitive, but the practice reflects
sound tax policy because it recognizes the fact that an
individual's net worth has increased by the cancellation of
debt. According to Commissioner v. Glenshaw, the Court
defined income as an accession to wealth, that is clearly
realized, and over which the taxpayer has complete
dominion<1>. When debt is cancelled, money that would have
been used to pay that loan is now free to be used on whatever
the taxpayer wants. Therefore, because certain assets have
been freed, the taxpayer has experienced an accession to
wealth. Additionally, under the rule of symmetry, a loan is
not considered income to the borrower nor is it a deduction to
the lender. A borrower's increased wealth when the loan is
taken out is also offset by the obligation to pay the same
amount. If the debt is cancelled, the symmetry is destroyed.
The borrower is in a much better position after the debt is
cancelled. Additionally, as noted by Debora A. Grier,
Professor of Law of Cleveland State University, in her
statement before the United State Senate Committee on Finance,
without this tax rule, "the borrower will have received
permanently tax-free cash in the year of the original
receipt," i.e. the year in which the borrower received the
loan. Even understanding the economic and legal policy for
taxing COD, most individuals still find the taxation of
cancelled home mortgage debt odd and even unfair.
5)Non-Recourse Debt . Non-recourse debt is a loan that is
secured by the pledge of collateral. If the borrower
defaults, the lender can seize the collateral, but the
recovery is limited to the collateral. 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. Property that is foreclosed upon is not
considered COD, even if the amount of the loan exceeds the
fair market value (FMV) of the property. However, if a lender
agrees to decrease the amount of the original debt to reflect
the current value of the property secured by the debt, the
transaction will be considered COD and subject to tax. This
is because the cancellation of non-recourse debt without a
transfer of property creates COD income for the taxpayer in an
---------------------------
<1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).
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amount equal to the amount cancelled by the lender.
California law provides relief to a solvent homeowner who
refinanced the first mortgage or took out a home equity loan
or a home equity line of credit. It provides 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.
6)Insolvency . COD is not included in income to the extent the
taxpayer is insolvent immediately before the debt is
cancelled. A taxpayer is insolvent immediately before the COD
to the extent that the amount of total liabilities exceeds the
FMV of all assets immediately before the cancellation. This
provision may be used in lieu of the qualified principal
residence indebtedness exclusion. It is important to
remember, however, that the exclusion applies only to the
extent of insolvency. As an example, assume a taxpayer has
discharged debt of $5,000. Before the cancellation of debt,
the taxpayer had $10,000 in liabilities and the FMV of all
assets was $7,000. This means that before the cancellation,
the taxpayer was insolvent to the extent of $3,000 dollars
(total liabilities minus FMV assets). Therefore, the taxpayer
may exclude $3,000 from income and include $2,000 as income of
the discharged debt.
7)Why exclude COD from Gross Income ? Despite the economics of
taxing COD, the rationale for excluding cancelled mortgage
from gross income has focused on minimizing hardship for
households in distress. Individuals who are in danger of
losing their homes, due in part to the economic downturn,
should not be forced to incur the additional hardship of
paying taxes on COD. It also reduces the burden on a borrower
who may be attempting to write-down the loan with their lender
or a short sale. On a macroeconomic level, economists have
argued that excluding cancelled mortgage from gross income may
help maintain consumer spending, which may help prevent a
recession.
As noted earlier, one of rationales for excluding mortgage
forgiveness from income is to help taxpayers remain in their
home. In some instances, a lender may be able to reduce the
loan amount to the home's current FMV and allow the taxpayer
to retain ownership of the home. For example, a taxpayer may
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owe $250,000 of residential debt, and after a modification,
the lender reduces the loan down to $200,000 and forgives
$50,000. Without an exclusion of the mortgage cancellation,
the $50,000 would be subject to taxation. If the taxpayer is
subject to a 25% tax rate, the tax liability would be $12,500.
Assuming the reduction in loan was done because the taxpayer
was facing financial difficulty, incurring a tax obligation on
COD may prevent the taxpayer from successfully remaining in
the home. [See, Congressional Research Service's report (CRS
report) entitled analysis of the Proposed Tax Exclusion for
Cancelled Mortgage Debt Income, dated January 8, 2008, 2 -8].
8)QPRI Includes Secondary Loans . The exclusion for COD income
realized by the taxpayer from the COD applies 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. However, the definition of QPRI 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.
Thus, existing law 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.
9)FTB Suggested Amendments . The FTB has suggested including an
operative date to clarify that the proposed changes to Revenue
& Taxation Code Section 17144.5 apply to discharges occurring
after January 1, 2013. For discharges occurring in 2007 or
2008, the total amount of non-taxable COD income is limited to
$250,000 ($125,000 in the case of a married /RDP individual
filing a separate return). This amount was later increased
for discharges occurring on or after January 1, 2009, and
before January 1, 2013, to $500,000 ($250,000 in the case of
married /RDP individual filing a separate return). Without an
operative date, this bill could be interpreted as
retroactively increasing the current limitation on 2007 and
2008 discharges from $250,000 ($125,000 in the case of a
married /RDP individual filing a separate return) to $500,000
($250,000 in the case of married /RDP individual filing a
separate return).
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Additionally, the FTB recommends adding the public law number
of the federal Act that provided the one-year extension of
mortgage forgiveness debt relief for federal tax purposes.
10)Related Legislation .
AB 856 (Jeffries), introduced in the 2011-12 legislative
session, would have conformed fully to the Mortgage
Forgiveness Debt Relief Act (MFDRA) as extended by the
Emergency Economic Stabilization Act (ESSA) to discharged debt
occurring on or after January 1, 2010, and before January 1,
2013. AB 856 was held by this Committee.
AB 111 (Niello), introduced in the 2009-10 legislative
session, would have provided the same exclusion from gross
income for mortgage forgiveness debt relief that is allowed
under federal law for discharges occurring on or after January
1, 2007, and before January 1, 2013. AB 111 was held by this
Committee.
SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the PIT
Law to conform to the federal extension of mortgage
forgiveness debt relief provided in the Emergency Economic
Stability Act, with the following modifications: (a) it
applies to discharges occurring in 2009, 2010, 2011, and 2012
tax years, (b) the total amount of QPRI is limited to $800,000
($400,000 in the case of a married individual or domestic
registered partner filing a separate return; (c) the total
amount excludable is limited to $500,000 ($250,000 in the case
of a married individual or domestic registered partner filing
a separate return); and (d) interest and penalties are not
imposed with respect to discharges that occurred in the 2009
taxable year.
AB 1580 (Calderon), introduced in the 2009-2010 legislative
session, was similar to SB 401 (Wolk). AB 1580 was vetoed by
the governor.
SB 97 (Calderon), introduced in the 2009-10 legislative
session, extended the provisions of PIT Law to allow a
taxpayer to exclude from his/her gross income the COD income
generated from the discharge of QPRI in 2009, 2010, 2011, or
2012 tax year. SB 97 never moved off the Senate Revenue &
Taxation Committee suspense file.
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SB 1055 (Machado), Chapter 282, Statutes of 2008, amended the
PIT Law to conform to the federal Act of 2007, except that it
imposed certain limitations on the amount of QPRI and COD
income eligible for the exclusion. SB 1055 specified that the
exclusion applied to a discharge of QPRI that occurred in the
2007 and 2008 taxable years.
AB 1918 (Niello), introduced in the 2007-08 legislative
session, was similar to SB 1055. AB 1918 modified federal law
to allow the exclusion for up to $1 million/$500,000 of QPRI
and did not impose any limitations on the amount of COD
income. AB 1918 was held in this Committee.
REGISTERED SUPPORT / OPPOSITION :
Support
California Association of Realtors
California Attorney General, Department of Justice
California Bankers Association
California Credit Union League
California Independent Bankers
California Mortgage Bankers Association
CalTax
Center for Responsible Lending
Opposition
None on file
Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916)
319-2098