BILL ANALYSIS Ó
AB 99
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Date of Hearing: March 23, 2015
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Philip Ting, Chair
AB 99
(Perea) - As Amended February 18, 2015
2/3 vote. Urgency. Fiscal committee.
SUBJECT: Personal income taxes: income exclusion: mortgage
debt forgiveness
SUMMARY: Extends for one additional taxable year, in modified
conformity to the recently enacted federal law, the tax relief
for income generated from the discharge of qualified principal
residence indebtedness (QPRI). Specifically, this bill:
1)Provides that Internal Revenue Code (IRC) Section 108,
relating to income from discharge of QPRI, as amended by
Section 102 of the Tax Increase Prevention Act of 2014, shall
apply, except as otherwise provided.
2)Applies discharges to QPRI occurring on or after January 1,
2014, and before January 1, 2015.
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3)Provides that, notwithstanding any other law, no penalties or
interest shall apply be due to the discharge of QPRI for the
2014 taxable year, regardless of whether or not a taxpayer
reports the discharge during the 2014 taxable year.
4)Makes 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 QPRI was discharged on and after
January 1, 2014, and before January 1, 2015, and does not
constitute a gift of public funds.
5)Provide that this is an urgency statute necessary for the
immediate preservation of the public peace, health, or safety.
EXISTING FEDERAL LAW:
1)Includes in the gross income of a taxpayer an amount of debt
that is discharged by the lender, except for any of the
following:
a) Debts discharged in bankruptcy;
b) Some or all of the discharged debts of an insolvent
taxpayer. A taxpayer is insolvent when the amount of the
taxpayer's total debt exceeds the fair market value of the
taxpayer's total assets;
c) Certain farm debts and student loans; or,
d) Debt discharged resulting from a non-recourse loan in
foreclosure. A non-recourse loan is a loan for which the
lender's only remedy in case of default is to repossess the
property being financed or used as collateral. (IRC
Section 108.)
2)Requires a taxpayer to reduce certain tax attributes by the
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amount of the discharged indebtedness in the case where the
indebtedness is excluded from the taxpayer's gross income.
(IRC Section 108.)
3)Excludes from a taxpayer's gross income cancellation of
indebtedness (COD) income that resulted from the discharge of
QPRI occurring on or after January 1, 2007, and before January
1, 2015.
4)Defines "QPRI" as acquisition indebtedness within the meaning
of IRC Section 163(h)(3)(B), which generally means
indebtedness incurred in the acquisition, construction or
substantial improvement of the principal residence of the
individual and secured by the residence. "QPRI" also includes
refinancing of such debt to the extent that the amount of the
refinancing does not exceed the amount of the indebtedness
being refinanced.
5)Allows married taxpayers to exclude from gross income up to $2
million in QPRI (married persons filing separately may exclude
up to $1 million of the amount of that indebtedness). For all
taxpayers, the amount of discharge of indebtedness generally
is equal to the difference between the adjusted issue price of
the debt being cancelled and the amount used to satisfy the
debt. For example, if a creditor forecloses on a home owned
by a solvent taxpayer and sells it for $180,000 but the house
was subject to a $200,000 mortgage debt, then the taxpayer
would have $20,000 of income from the COD.
6)Specifies that if, immediately before the discharge, only a
portion of a discharged indebtedness is QPRI, then the
exclusion applies only to so much of the amount discharged as
it exceeds the port of the debt that is not QPRI. For
example, a taxpayer's principal residence is secured by an
indebtedness of $1 million, of which only $800,000 is QPRI.
If the residence is sold for $700,000 and $300,000 debt is
forgiven by the lender, then only $100,000 of the COD income
may be excluded under IRC Section 108.
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7)Defines the term "principal residence" pursuant to IRC Section
121 and the applicable regulations.
8)Excludes from tax a gain from the sale or exchange of the
taxpayer's principal residence if, during the five-year period
ending on the date of the sale or exchange, the property has
been owned and used by the taxpayer as his/her principal
residence for periods aggregating two year or more. The
amount of gain eligible for the exclusion is $250,000
(taxpayers filing single) or a $500,000 (for married taxpayers
filing a joint return).
9)Requires a taxpayer to reduce the basis in the principal
residence by the amount of the excluded COD income.
EXISTING STATE LAW:
1)Conforms to the federal income tax law relating to the
exclusion of the discharged QPRI from the taxpayer's gross
income, with the following modifications:
a) Applies to the discharge of indebtedness occurring on or
after January 1, 2007 and before January 1, 2014.
b) The maximum amount of QPRI is limited to $800,000
($400,000 for married/RDP filing separate).
c) For discharges occurring in 2007 or 2008, the total
amount of non-taxable COD income is limited to $250,000
($125,000 in the case of a married /RDP individual filing a
separate return).
d) For discharges occurring on or after January 1, 2009,
and before January 1, 2014, the maximum cancellation of
debt income exclusion is $500,000 ($250,000 for married/RDP
filing separate).
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e) Requires individual taxpayers to pay their estimated
California income tax in four installments over the taxable
year. Imposes a penalty for the underpayment of estimated
tax, which is the difference between the amount of tax
shown on the return for the taxable year and the amount of
estimated tax paid. However, no underpayment penalty or
interest is assessed for the 2007, 2009, and 2013 taxable
year.
FISCAL EFFECT: The Franchise Tax Board (FTB) estimates an
annual revenue loss of $42 million in fiscal year (FY)
2014-2015, and $5.2 million in FY 2015-16.
COMMENTS:
1)Author's Statement : The author provided the following
statement in support of this bill:
AB 99 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.
2)Arguments in Support : Proponents of this bill state that
"when debt is forgiven by a lender as part of an agreement
with a borrower using the short sale process or a principal
reduction, the borrower should not be penalized on their state
income taxes. Many borrowers who faced foreclosure last year
and successfully negotiated a loan modification may well find
themselves once again unable to make their mortgage payment if
they are saddled with a tax burden resulting from forgiven
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debt."
3)Mortgage Debt Forgiveness: Background . SB 1055 (Machado),
Chapter 282, Statues of 2008, provided modified conformity to
the Mortgage Forgiveness Debt Relief Act (MFDRA) for discharge
of mortgage indebtedness in 2007 and 2008 tax years. SB 401
(Wolk), Chapter 14, Statues of 2010, provided 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/RDP filing separate
return) to $500,000 ($250,000 in case of married
individual/RDP filing a separate return). On January 2, 2013,
the Federal Government enacted the Federal American Taxpayer
Relief Act (FATRA) as part of the "fiscal cliff" deal. FATRA
extended the exclusion from gross income for 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 and before January 1, 2014. On December 19, 2014, the
Federal Government enacted the Tax Increase Prevention Act and
again extended, for one additional year, the exclusion from
gross income for COD generated from the discharge of QPRI
occurring on or after January 1, 2014 and before January 1,
2015.
4)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, the 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
---------------------------
<1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).
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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 State Senate Committee on Finance,
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.
5)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 Section 580b) 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 original debt to reflect
the current value of the property secured by the debt, the
transaction will be considered COD and subject to tax - 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/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
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outstanding debt to reflect the home's current value.
6)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 QPRI 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 (total liabilities minus FMV assets). Therefore, the
taxpayer may exclude $3,000 from income and include $2,000 as
income of the discharged debt.
7)Why exclude COD from Gross Income ? Despite the economics of
taxing COD, the rationale for excluding 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. The exclusion of COD from gross income
also reduces the burden on a borrower who may be attempting to
write-down the loan with his or her 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 to $200,000 and forgives $50,000.
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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
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),
Analysis of the Proposed Tax Exclusion for Cancelled Mortgage
Debt Income, January 8, 2008, 2 -8.]
The recession and drop in housing values are the main factors
that led to the original exclusion of COD from gross income.
However, over the last few years, the unemployment rate has
steadily declined and home values have substantially
increased. As of November 2014, California's unemployment
rate stood at 7.2%, five percentage points lower than its
post-recession peak of 12.4%, but 2.4% higher than its
pre-recession low of 4.8%. (Public Policy Institute of
California, The California Economy: Unemployment Update,
December 2014.) Additionally, the number of seriously
"underwater" homes went from a peak of 12.8 million in 2012 to
just over 7 million in the fourth quarter of 2014. The
reduction in underwater homes has primarily been triggered by
a 35% increase in the national median home value since
bottoming out in 2012. (RealtyTrac, Seriously Underwater
Properties Decrease by 2.2 Million in 2014, Down 5.8 Million
From Peak Negative Equity in Q2 2012, January 21, 2015.) In
light of substantial improvements to the economy, the
Committee may wish to consider whether an extension of the
exclusion for COD generated from the discharge of QPRI is
warranted.
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.
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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.
9)Prior Legislation :
a) AB 1393 (Perea), Chapter 152, Statute of 2014, extended
California's modified conformity to the Mortgage
Forgiveness Debt Relief Act for discharges of QPRI until
January 1, 2014.
b) AB 42 (Perea), of the 2013-14 Legislative Session, would
have extended, for one additional taxable year, in modified
conformity to federal law, the tax relief generated from
the discharge of QPRI. AB 42 was held by the Assembly
Appropriations Committee.
c) SB 30 (Calderon), of the 2013-14 Legislative Session,
would have extended for one additional taxable year, in
modified conformity to federal law, the tax relief
generated from the discharge of QPRI. SB 30 was held by
the Assembly Appropriations Committee.
d) AB 856 (Jeffries), of the 2011-12 Legislative Session,
would have conformed fully to the Mortgage Forgiveness Debt
Relief Act as extended by the Emergency Economic
Stabilization Act to discharged debt occurring on or after
January 1, 2010, and before January 1, 2013. AB 856 was
held by this Committee.
e) AB 111 (Niello), of the 2009-10 Legislative Session,
would have provided the same exclusion from gross income
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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 this
Committee.
f) SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the
PIT Law to conform to the federal extension of mortgage
forgiveness debt relief provided in the Emergency Economic
Stability Act, with the following modifications: (i) it
applies to discharges occurring in 2009, 2010, 2011, and
2012 tax years; (ii) 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; (iii)
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, (iv)
interest and penalties are not imposed with respect to
discharges that occurred in the 2009 taxable year.
g) AB 1580 (Calderon), of the 2009-10 Legislative Session,
was similar to SB 401 (Wolk). AB 1580 was vetoed.
h) 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/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.
i) SB 1055 (Machado), Chapter 282, Statutes of 2008,
amended the PIT Law to conform to the federal Act of 2007,
except that it 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.
j) AB 1918 (Niello), of the 2007-08 Legislative Session,
was similar to SB 1055. AB 1918 modified federal law to
allow the exclusion for up to $1 million/$500,000 of QPRI
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and did not impose any limitations on the amount of COD
income. AB 1918 was held by this Committee.
REGISTERED SUPPORT / OPPOSITION:
Support
Board of Equalization Member George Runner
California Association of Realtors
California Bankers Association
California Credit Union League
California Mortgage Bankers Association
California Society of Enrolled Agents
California Taxpayer Association
1 individual
Opposition
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None on file
Analysis Prepared by:Carlos Anguiano / REV. & TAX. / (916)
319-2098