BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: AB 1393 HEARING: 5/14/14 AUTHOR: Perea FISCAL: Yes VERSION: 4/7/14 TAX LEVY: No CONSULTANT: Grinnell MORTGAGE DEBT CONFORMITY Conforms state law to federal law for mortgage debt forgiveness. Background and Existing Law California law does not automatically conform to changes to federal tax law, except for specific retirement provisions. Instead, the Legislature must affirmatively conform to federal changes. Conformity legislation is introduced either as individual tax bills to conform to specific federal changes, like the Regulated Investment Company Modernization Act (AB 1423, Perea, 2011), or as one omnibus bill that provides that state law conforms to federal law as of a specified date, currently January 1, 2009 (SB 401, Wolk, 2010). When a lender cancels a borrower's debt, federal and state law generally treats the amount of debt cancelled as income taxable to the borrower. Taxpayers do not include borrowed funds in income in the year he or she receives loan proceeds because of the obligation to repay the loan; the taxpayer is financially no better off because the loan must be repaid. When lenders reduce the repayable amount, the taxpayer realizes a gain in his or her financial situation because a portion of the loan proceeds already received and not previously taxed need not be repaid. In U.S .v. Kirby Lumber Co., 284 US 1 (1931), the United States Supreme Court held that a company that had issued $12 million in bonds and later repurchased some of them at less than their face amount made a clear gain which should be treated as income to the taxpayer. Congress subsequently deemed cancelled debt as income, with exceptions for: Debts discharged in bankruptcy When the taxpayer is insolvent, debt discharge is excluded up to the amount of the insolvency, but AB 1393 - 4/7/14 -- Page 2 triggers specified basis adjustments, Certain farm debts, and Debt discharge resulting from a non-recourse loan in foreclosure. Many Californians experienced rapid declines in the market values of their homes in recent years, so much so that the value was less than the amount of debt they incurred to buy it. Some homeowners have sufficient income, equity, and home value to refinance, but others cannot, and instead attempt to sell their home for less than they are obligated to repay their lender, which is known as a "short-sale." Instead of a simple transaction between buyer and seller, a short sale requires a third party - the seller's lender - to agree to cancel the borrower's debt in an amount equal to the difference between the new sales price of the home and the original amount of the debt issued to the borrower to buy it, plus any additional debt secured by the property. For example, a lender must cancel $150,000 in debt for a borrower who purchased a home in 2005 for $400,000, but wants to short sell it this year for $250,000. The lender must assess the current housing market, the current borrower's ability to repay the loan, and federal and state incentives when considering whether to accept this loss. While lenders can claim principal forgiven as a deductible business loss, the borrower faces a significant tax bill in addition to the loss of any equity in the home at the time of sale absent legislation. Additionally, any loan modification where the lender forgives principal as part of a loan modification, a deed-in-lieu of foreclosure, or a foreclosure usually results in taxable income for the borrower In 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), which provides that taxpayers may exclude from income qualified principal residence indebtedness cancelled after January 1, 2007 but before January 1, 2010. Married taxpayers may exclude up to $2 million in qualified principal residence indebtedness, while married persons filing separate or single persons may exclude up to $1 million. Taxpayers may only exclude indebtedness incurred to purchase, construct, or improve the taxpayer's principal residence, defined as the residence that the taxpayer owns and uses as his or her principal residence for at least two out of the last five years. The Emergency Economic Stabilization Act of 2008 AB 1393 - 4/7/14 -- Page 3 extended the exclusion until January 1, 2013. On January 2, 2013, Congress enacted the American Taxpayer Relief Act of 2012, which extended the exclusion for the 2013 taxable year. California first conformed to MFDRA in 2008, and again in 2010, for debt discharged on or before December 31, 2012, with the following differences (SB 1055, Machado, 2008, and SB 401, Wolk, 2010): Taxpayers may only exclude up to $250,000 single/ $500,000 joint of cancelled debt from income. Taxpayers may only exclude indebtedness on loans up to $400,000 single/$800,000 joint of qualified principal residence indebtedness. The taxpayer must first reduce any amount excluded for state tax purposes by any debt forgiven on loan amounts above $400,000/$800,000. Mortgage debt relief only applies to recourse loans, not non-recourse ones. A loan is non-recourse when the lender can only repossess the asset that secures the loan to satisfy delinquent debt; a recourse loan allows a lender to petition a court for a personal deficiency judgment against a delinquent borrower, a public record that allows the lender to collect the delinquent amount from the borrower in a variety of ways. In California, all original loans to purchase homes in the state must be nonrecourse, but the status often changes to recourse when the home is refinanced, or the borrower takes out a second mortgage or a home equity line of credit. In 2010, the Legislature prohibited a lender from obtaining a deficiency judgment for any first mortgage deficiency after a short sale of a residence (SB 931, Ducheny). In 2011, the Legislature extended that treatment for all residential mortgages, including second mortgages after a short sale (SB 458, Corbett). Soon after, tax scholars argued that the Legislature's action on deficiency judgments essentially converted recourse mortgage debt from a short sale to non-recourse debt. Last February, the Committee approved SB 30 (Calderon), which conformed California law to MFDRA for the 2013 taxable year. The Senate Committee on Appropriations subsequently amended the measure to make its enactment contingent on another bill SB 391 (DeSaulnier). The AB 1393 - 4/7/14 -- Page 4 Assembly hasn't approved either bill. Additionally, the Internal Revenue Service (IRS) wrote to Senator Barbara Boxer in December, 2013 indicating its belief that the Legislature's action to bar lenders from issuing deficiency judgments to satisfy recourse debts changes the debt to non-recourse in short sales, therefore taxpayers should not include the income for California purposes. IRS's letter did not address loan modifications that result in principal forgiveness, deeds-in-lieu of foreclosure, or foreclosures. Proposed Law Assembly Bill 1393 extends California's modified conformity to the Mortgage Debt Forgiveness Relief Act for discharges of qualified principal residence indebtedness until January 1, 2014. The bill states legislative findings and declarations stating that its retroactive application does not constitute a gift of public funds, and the measure continuously appropriates funds to Franchise Tax Board (FTB) to pay amounts necessary. State Revenue Impact According to FTB, AB 1393 results in revenue losses of $35 million in 2013-14, and $4 million in 2014-15. Comments 1. Purpose of the bill . According to the author, "AB 1393 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 a loan modification, a bank can 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 AB 1393 - 4/7/14 -- Page 5 be taxed on "phantom" income they never received." 2. Debt and Equity . Federal and state tax law consistently prefers debt over equity: taxpayers can deduct mortgage interest from income and interest payments on debt incurred for a business, but cannot deduct any returns to equity or saved cash. Taxpayers will more often incur debt instead of using equity because taxpayers can use interest expense deductions to reduce other income subject to tax. Tax incentives for individuals and firms to incur debt may not directly cause social and economic problems, but they have surely contributed to the almost $13 trillion in U.S. household debt, and $12 trillion in non-financial business debt. AB 1393 furthers this preference. The measure cancels, for state purposes, income received by individuals who incurred debt to purchase a home but sell it for a lesser amount, while taxpayers who did the same with homes purchased with cash cannot deduct any losses. Is this treatment fair for taxpayers who pay for homes by saving money instead of borrowing it, and if not, does this treatment create a moral hazard? Borrowers who know no tax consequence exists for default may be less responsible about incurring and paying debt, potentially leading to over-borrowing and defaults. The Committee may wish to consider furthering the tax code's existing, potentially dangerous preference for debt. 3. How does this work ? AB 1393 doesn't apply to all short sales or principal reductions, and doesn't forgive all kinds of debt secured by a home. Additionally, AB 1393 does not perfectly conform to federal law, so some taxpayers may not be able to exclude income for California purposes that they can for federal tax. Important considerations for taxpayers include: First, AB 1393 only applies to recourse loans, not non-recourse ones, as discussed above. Second, AB 1393 only applies to the taxpayer's principal place of residence, defined as the home that the taxpayer owns and uses as a principal residence for at least two out of the last five years. AB 1393 does not forgive cancelled debt incurred on investment or business property, or second homes. Third, AB 1393 only forgives debt incurred by the taxpayer to build, purchase, or substantially improve the home. If the taxpayer incurred debt secured by the home, but spent the proceeds on non-home AB 1393 - 4/7/14 -- Page 6 improvement purposes, any debt cancelled by the lender will still result in taxable income for the borrower. Fourth, AB 1393 applies the "ordering rule" that differentiates indebtedness used to acquire and improve the house and indebtedness used for something else. For example, a taxpayer has an $800,000 loan, of which $200,000 is not qualified personal residence indebtedness (such as a home equity loan to send a child to college). The property is sold for $500,000. The $300,000 difference between the loan amount ($800,000), and the sales price ($500,000), must be reduced by the $200,000 in non-qualified personal residence indebtedness, meaning that $100,000 in cancelled debt is excluded for tax purposes, but $200,000 must be included as income. Both federal and state laws apply this rule. Lastly, California has never fully conformed to MFDRA, instead differing in two key respects that AB 1393 retains. First, the maximum amount of cancelled debt that can be excluded from income is $250,000 (single)/$500,000 (joint) in California, but unlimited for federal income tax - SB 401 doubled these limits initially enacted by AB 1055. Second, the taxpayer cannot exclude cancelled debt on loans above $400,000 (single)/$800,000 (joint), but $1 million (single)/$2 million (joint) for federal tax. On loans above those amounts, the taxpayer reduces his or her cancelled debt exclusion by the amount of the loan that exceeds the threshold. For example, a taxpayer filing jointly with $200,000 in cancelled debt on a $900,000 loan, includes $100,000 in cancelled debt as income, and excludes $100,000 [$200,000 - ($900,000 - $800,000)]. 4. A fine mess . California's lack of conformity with federal law for debt forgiven in the 2013 taxable year for debt forgiveness has caused a significant degree of taxpayer hardship. While individuals with debt forgiveness from a short sale in 2013 can exclude the income by virtue of the IRS letter, they do so in conflict with the law, as neither SB 30 nor AB 1393 has yet been enacted. Additionally, the IRS only issued a letter, not a regulation, which IRS recently indicated that it is reviewing. If IRS changes its mind, FTB would likely follow IRS's guidance. Taxpayers with debt forgiveness income that didn't come from a short sale, were bound by AB 1393 - 4/7/14 -- Page 7 current law's lack of conformity in the 2013 taxable year, and had to include the income in their returns filed before the April 15th due date, or pay 90% of approximate tax amount when filing an extension or face penalties. While AB 1393 would address the income exclusion, it does so after the typical filing deadline of April 15, 2013. As such, taxpayers will have to file amended returns with a claim for refund of state taxes paid based on including debt forgiveness income that weren't included for federal taxes even if the Legislature enacts the bill. 5. Technicals . FTB and Committee Staff recommend deleting the measure's continuous appropriation, as existing law already directs FTB to pay refunds from the Tax Relief and Refund Account. 6. Urgency . AB 1393 is an urgency statute, and must be approved by 2/3 vote of each house of the Legislature. Support and Opposition (5/8/14) Support : California Bankers Association; California Reinvestment CoalitionCenter for Responsible Lending; Consumers Union; Housing and Economic Rights Advocate. Opposition : Unknown.