BILL ANALYSIS �
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: SB 30 HEARING: 3/13/13
AUTHOR: Calderon FISCAL: Yes
VERSION: 3/6/13 TAX LEVY: Yes
CONSULTANT: Grinnell
MORTGAGE DEBT CONFORMITY
Conforms state law to federal treatment for the
cancellation of mortgage indebtedness.
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, clarifying a previous
holding in Bowers v. Kerbaugh Empire Co, 271 U.S. 170
(1926). Congress subsequently deemed cancelled debt as
income, with exceptions for:
Debts discharged in bankruptcy
When the taxpayer is insolvent, debt discharge is
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excluded up to the amount of the insolvency, but
triggers specified basis adjustments
Certain farm debts, and
Debt discharge resulting from a non-recourse loan
in foreclosure.
Many Californians have seen the market values of their
homes decline below the amount of debt they incurred to buy
it. Some homeowners have sufficient income, equity, and
home value to refinance. Others cannot refinance, and
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 because any loan
amount forgiven by the lender is income taxable to the
borrower absent legislation. Additionally, any loan
modification that results in reduced principal may also
result in taxable income for the borrower.
In 2007, Congress enacted the Mortgage Forgiveness Debt
Relief Act of 2007 (MFDRA), which provides that taxpayers
may also 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
SB 30 - 3/6/13 -- 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.
Proposed Law
Senate Bill 30 extends California's modified conformity to
the Mortgage Debt Forgiveness Relief Act for discharges of
qualified principal residence indebtedness until January 1,
2014.
State Revenue Impact
According to the Franchise Tax Board (FTB), SB 30 results
in revenue losses of $50 million in the 2013-14 fiscal
year, and $5 million in 2014-15.
Comments
1. Purpose of the bill . According to the author, "SB 30
is a federal tax conformity bill that extends the sunset
date on an important piece of legislation that has lapsed
at the end of the 2012 year. SB 30 is one part of a
multi-part solution to addressing California's mortgage
problem. Families are stuck in financial limbo. Homeowners
currently in short sale negotiations cannot finalize these
transactions without potentially incurring a tax they
already cannot afford. Yet they do not have the luxury of
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time to wait to see if the state will act to provide relief
from this tax. Right now if a lender agrees to forgive some
of a borrower's mortgage debt that forgiven debt is taxed
as ordinary income in the year which the debit is forgiven.
Three common situations in which forgiven debt is taxable
are 1) foreclosures on refinanced mortgages 2) short sales
and 3) deeds in lieu of foreclosure. SB 30 will provide
immediate tax relief to Californians upon its enactment.
Once the bill is signed into law, any qualifying California
taxpayer will be able to claim the bill's tax relief on his
or her 2013 tax return. Any taxpayer who files his or her
2013 tax return before the bill becomes law and who wishes
to take advantage of the bill's tax relief will be able to
file an amended return upon the bill's signature. Those
taxpayers will not be subject to penalties or interest if
they fail to pay state income tax on forgiven debt when
they file their 2013 tax returns. SB 30 is the right thing
to do. Families forced to make the difficult decision to
sell their home as a short sale are already in financial
trouble. They simply cannot afford to pay an additional
tax on money they have never actually received. SB 30
will extend California's tax relief in this area through
tax year 2014, in conformity with federal law."
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 and firms will more often
agree to incur debt instead of use equity because taxpayers
can use interest expense deductions 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. SB 30 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 because tax law treats principal residences as
personal use assets. The Committee may wish to consider
furthering the tax code's existing, potentially dangerous
preference for debt, especially in a time when excessive
debt levels are stifling aggregate demand necessary for
economic growth. Additionally, SB 30 forgives the tax
SB 30 - 3/6/13 -- Page 5
penalty on the borrower who defaults on his or her
obligation, while the cash buyer suffers a non-deductible
loss. 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.
3. How does this work ? SB 30 doesn't apply to all short
sales or principal reductions, and doesn't forgive all
kinds of debt secured by a home. Additionally, SB 30 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, SB 30 only applies to recourse loans, not
non-recourse ones. A loan is non-recourse when the
lender's only recourse against the borrower is to
repossess the asset that secures the loan. The
California Code of Civil Procedure requires that all
original loans to purchase homes in the state must be
nonrecourse. However, the nature of the debt often
changes to recourse when the home is refinanced or the
borrower takes out a second mortgage or a home equity
line of credit. Cancelling non-recourse debt does not
result in income, so SB 30's forgiveness is not
needed.
Second, SB 30 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. SB 30
does not forgive cancelled debt incurred on investment
or business property, or second homes.
Third, SB 30 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
improvement purposes, any debt cancelled by the lender
will still result in taxable income for the borrower.
Fourth, SB 30 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
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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 SB
30 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)].
Support and Opposition (3/7/13)
Support : Attorney General Kamala Harris, Board of
Equalization Chairman Jerome Horton, California Bankers
Association, California Mortgage Bankers Association,
California Society of Enrolled Agents, California Taxpayers
Association, Southwest Riverside County Association of
Realtors.
Opposition : None received.