BILL ANALYSIS Ó
AB 1393
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CONCURRENCE IN SENATE AMENDMENTS
AB 1393 (Perea)
As Amended June 15, 2014
2/3 vote. Urgency
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|ASSEMBLY: | |(April 18, |SENATE: |34-0 |(June 30, |
| | |2013) | | |2014) |
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(vote not relevant)
Original Committee Reference: INS.
SUMMARY : Extends the tax relief for income generated from the
discharge of qualified principal residence indebtedness (QPRI)
through taxable year 2013, in modified conformity to federal
law.
The Senate amendments delete the Assembly version of this bill,
and instead:
1)Provide 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)Specify that IRC Section 108 applies to discharges of QPRI
occurring on or after January 1, 2013, and before January 1,
2014.
3)Provide that no penalties or interest shall be due with
respect to the discharge of qualified principal residence
indebtedness during the 2013 taxable year, regardless of
whether the taxpayer reports the discharge on his or her
income tax return for the 2013 taxable year.
4)Make findings and declarations stating that the retroactive
application of this bill is necessary for the public purpose
of conforming to federal law, and thereby preventing undue
hardship to taxpayers whose qualified principal residence
indebtedness was discharged on and after January 1, 2013, and
before January 1, 2014, and do not constitute a gift of public
funds.
5)Provide that this is an urgency statute necessary for the
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immediate preservation of the public peace, health, or safety.
AS PASSED BY THE ASSEMBLY , this bill repealed three obsolete
requirements that certain studies be undertaken.
FISCAL EFFECT : According to the Senate Appropriations
Committee, the Franchise Tax Board estimates that this bill
would result in General Fund revenue losses of $35 million in
2013-14 and $4 million in 2014-15.
COMMENTS : This bill was substantially amended in the Senate and
the Assembly-approved version of this bill was deleted. This
bill, as amended in the Senate, is inconsistent with Assembly
actions. However, the provisions and subject matter of this
bill have been heard by the Revenue and Taxation Committee.
The author has provided the following statement in support of
this bill:
AB 1393 would extend the tax relief on forgiveness of
mortgage debt by conforming California law to federal
law. After a loan modification 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 Californians may be
taxed on "phantom" income they never received.
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. SB 401 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/registered domestic partner (RDP)
filing separate return) to $500,000 ($250,000 in case of married
individual/RDP filing a separate return). On January 2, 2013,
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the Federal Government enacted FATRA as part of the "fiscal
cliff" agreement. The FATRA extended the exclusion from gross
income for cancellation of debt (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.
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 (1955) 348 U.S.
426, the United States Supreme 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 States Senate Finance Committee, 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.
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 (CCP) Section 580(b)) 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
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<1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).
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original debt to reflect the current value of the property
secured by the debt, the transaction will be considered COD and
subject to tax because the cancellation of non-recourse debt
without a transfer of property creates COD income for the
taxpayer in an 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. California law provides relief
to a solvent homeowner who benefited from a reduction of his or
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.
In September 19, 2013, the Internal Revenue Service (IRS) sent a
letter to United States Senator Barbara Boxer addressing the
taxation of debt cancellation with respect to short sales. The
IRS stated that a homeowner's obligation under the
anti-deficiency provision of CCP Section 580(e) is non-recourse
debt, meaning that the homeowner will not have cancellation of
indebtedness income as a result of the short sale. The letter
did not address loan modifications that result in principal
forgiveness or foreclosures but provided substantial tax relief
for those completing short sales.
On April 29, 2014, the IRS released a second letter clarifying
their initial interpretation of CCP Section 580(e). In the
second letter, the IRS took a step back and explained that the
statements made in their first letter were overly broad because
CCP Section 580(e) applies to both purchase-money loans and
non-purchase-money loans, and applies to property that may or
may not be the taxpayer's principal residence; this is
problematic because non-purchase-money loans subject to
California's anti-deficiency statues generally appear to be
recourse loans from their inception, potentially making
forgiveness of those loans subject to tax. The second letter
does maintain some relief for taxpayers completing short sales,
but does so by relying on CCP Section 580(a)(3), which applies
to purchase-money loans to acquire a principal residence. For
federal tax purposes, purchase-money loans described in CCP
Section 580(a)(3) are, from inception, non-recourse loans, and
gains resulting from a short sale may be excluded from gross
income. Because the second letter relied on non-recourse loans
under CCP Section 580(a)(3), there are a number of short sales
and foreclosures that may result in taxable income. Extending
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the tax relief for income generated from the discharge of
qualified principal residence indebtedness for the 2013 taxable
year will provide tax relief to those individuals not
specifically addressed in the two IRS letters.
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, meaning 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.
Why exclude COD from Gross Income? Despite the economics of
taxing COD, the rationale for excluding a 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.
Excluding COD from gross income 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
homes. 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 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
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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, p. 2-8.]
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.
Related Legislation: AB 42 (Perea) of the current legislative
session, extends for one additional taxable year, in modified
conformity to federal law, the tax relief for income generated
from the discharge of (QPRI). AB 42 was held by the Assembly
Appropriations Committee.
SB 30 (Calderon) of the current legislative session, extends for
one additional taxable year, in modified conformity to federal
law, the tax relief for income generated from the discharge of
QPRI. SB 30 was held by the Assembly Appropriations Committee.
Prior Legislation: AB 856 (Jeffries), of the 2011-12
legislative session, would have conformed fully to the MFDRA as
extended by the Emergency Economic Stabilization Act (EESA) to
discharged debt occurring on or after January 1, 2010, and
before January 1, 2013. AB 856 was held by the Assembly Revenue
and Taxation Committee.
AB 111 (Niello), of 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 the Assembly Revenue and
Taxation Committee.
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SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the
Personal Income Tax (PIT) Law to conform to the federal
extension of mortgage forgiveness debt relief provided in the
EESA, with the following modifications: 1) it applies to
discharges occurring in 2009, 2010, 2011, and 2012 tax years; 2)
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; 3) 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, 4) interest and penalties are not imposed with
respect to discharges that occurred in the 2009 taxable year.
AB 1580 (Calderon) of the 2009-10 legislative session, was
similar to SB 401. AB 1580 was vetoed.
SB 97 (Calderon) of the 2009-10 legislative session, would have
extended the provisions of PIT Law to allow a taxpayer to
exclude from his or her gross income the COD income generated
from the discharge of QPRI in 2009, 2010, 2011, or 2012 tax
year. SB 97 was held on the Senate Revenue and Taxation
Committee's Suspense File.
SB 1055 (Machado), Chapter 282, Statutes of 2008, amended the
PIT Law to conform to the federal Act of 2007, except that SB
1055 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) of the 2007-08 legislative session, was similar
to SB 1055. AB 1918 would have 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 the Assembly Revenue and Taxation Committee.
Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916)
319-2098
FN: 0004159
AB 1393
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