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
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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
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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
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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
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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
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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.