BILL ANALYSIS                                                                                                                                                                                                    Ó




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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  


          ---------------------------
          <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 











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