BILL ANALYSIS Ó AB 99 Page A ASSEMBLY THIRD READING AB 99 (Perea) As Amended May 20, 2015 2/3 vote. Urgency ------------------------------------------------------------------- |Committee |Votes |Ayes |Noes | | | | | | | | | | | |----------------+------+--------------------+----------------------| |Revenue & |9-0 |Ting, Brough, | | |Taxation | |Dababneh, Gipson, | | | | |Roger Hernández, | | | | |Mullin, Patterson, | | | | |Quirk, Wagner | | | | | | | |----------------+------+--------------------+----------------------| |Appropriations |17-0 |Gomez, Bigelow, | | | | |Bonta, Calderon, | | | | |Chang, Daly, | | | | |Eggman, Gallagher, | | | | | | | | | | | | | | |Eduardo Garcia, | | | | |Gordon, Holden, | | | | |Jones, Quirk, | | | | |Rendon, Wagner, | | | | |Weber, Wood | | | | | | | | | | | | ------------------------------------------------------------------- AB 99 Page B 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 Tax Increase Prevention Act of 2014 Section 102, shall apply, except as otherwise provided. 2)Applies discharges to QPRI occurring on or after January 1, 2014, and before January 1, 2015. 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. FISCAL EFFECT: According to the Assembly Appropriations Committee: 1)Minor and absorbable administrative costs to the Franchise Tax AB 99 Page C Board. 2)Estimated General Fund revenue decreases of $47 million and $5 million in Fiscal Year 2014-15 and Fiscal Year 2015-16, respectively. No estimated revenue impact thereafter. 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 debt." 3)Arguments in Opposition: None submitted. AB 99 Page D 4)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/registered domestic partners (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 cancellation of indebtedness (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. 5)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 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 ---------------------------- <1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). AB 99 Page E 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. 6)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 outstanding debt to reflect the home's current value. 7)Insolvency: COD is not included in income to the extent the taxpayer is insolvent immediately before the debt is cancelled. AB 99 Page F 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. 8)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. 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 AB 99 Page G 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 seven 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. 9)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, AB 99 Page H 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. Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916) 319-2098 FN: 0000638