BILL ANALYSIS                                                                                                                                                                                                    Ó



          SENATE COMMITTEE ON GOVERNANCE AND FINANCE
                         Senator Robert M. Hertzberg, Chair
                                2015 - 2016  Regular 

                              
          
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          |Bill No:  |AB 99                            |Hearing    | 6/17/15 |
          |          |                                 |Date:      |         |
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          |Author:   |Perea                            |Tax Levy:  |No       |
          |----------+---------------------------------+-----------+---------|
          |Version:  |5/20/15                          |Fiscal:    |Yes      |
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          |Consultant|Grinnell                                              |
          |:         |                                                      |
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               Personal income taxes:  income exclusion:  mortgage debt  
                                     forgiveness



          Extends California's modified conformity to federal law relating  
          to mortgage debt forgiveness.


           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 treat 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 that  
          have already been received and not previously taxed need not be  







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          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 which should be treated  
          as income to the taxpayer.  Congress subsequently deemed  
          cancelled debt as income, with exceptions for:
                 Debts discharged in bankruptcy 
                 When the taxpayer is insolvent, debt discharge is  
               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 experienced rapid declines in the market  
          values of their homes in recent years, so much so that the value  
          was less than the amount of debt they incurred to buy it.  Some  
          homeowners have sufficient income, equity, and home value to  
          refinance, but others cannot, and instead 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  
          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 absent  
          legislation.  Additionally, any loan modification where the  
          lender forgives principal as part of a loan modification, a  
          deed-in-lieu of foreclosure or a foreclosure usually results in  
          taxable income for the borrower

          In 2007, Congress enacted the Mortgage Forgiveness Debt Relief  
          Act of 2007 (MFDRA), which provides that taxpayers may exclude  
          from income qualified principal residence indebtedness cancelled  
          after January 1, 2007 but before January 1, 2010.  Married  








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          taxpayers may exclude up to $2 million in qualified principal  
          residence indebtedness, while married persons filing separately  
          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 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.  In 2014, Congress  
          again extended mortgage debt forgiveness through the 2014  
          taxable year when it enacted the Tax Increase Prevention Act.

          California first conformed to MFDRA in 2008, and again in 2010,  
          for debt discharged on or before December 31, 2012, and  
          additionally provided that no penalties or interest applies for  
          discharge of qualified principal residence indebtedness,  
          regardless of whether the taxpayer reports the discharge on his  
          or her income tax return (SB 1055, Machado, 2008, and SB 401,  
          Wolk, 2010).  However, those bills applied slightly different  
          limits than federal law:
                 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. 

          The Legislature extended mortgage debt relief for discharges of  
          indebtedness until January 1, 2014, last year (AB 1393, Perea),  
          but remains out of conformity for discharges that occurred last  
          year, meaning that affected taxpayers have to include cancelled  
          debt as income in the 2014 taxable year.  The author wants to  
          extend forgiveness for discharges of indebtedness that occurred  
          last year by extending the income exclusion.

           Proposed Law

           Assembly Bill 99 extends California's modified conformity to the  
          Mortgage Forgiveness Debt Relief Act for discharges of qualified  
          principal residence indebtedness until January 1, 2015.









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          The bill states legislative findings and declarations stating  
          that its retroactive application does not constitute a gift of  
          public funds.




           State Revenue Impact

           According to the Franchise Tax Board, AB 99 results in revenue  
          losses of $47 million in 2014-15, and $5.2 million in 2015-16.


           Comments

           1.   Purpose of the bill  .  According to the author, "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.  This bill would provide  
          much-needed state-level relief to homeowners facing financial  
          hardship because of the mortgage crisis, and better allow them  
          to afford and retain homeownership."

          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 will more often incur debt instead of using equity  
          because taxpayers can use interest expense deductions to 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 $13.5  
          trillion in U.S. household debt, and $12 trillion in  
          non-financial business debt.  AB 99 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.  Is this treatment  
          fair for taxpayers who pay for homes by saving money instead of  








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          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.  Legislators  
          should consider the potential risks of the tax code's existing  
          preference for debt.

          3.   One, but not the same  .  Mortgage debt relief only applies to  
          recourse loans, not non-recourse ones.  A loan is non-recourse  
          when the lender can only repossess the asset that secures the  
          loan to satisfy delinquent debt; a recourse loan allows a lender  
          to petition a court for a personal deficiency judgment against a  
          delinquent borrower, a public record that allows the lender to  
          collect the delinquent amount from the borrower in a variety of  
          ways.  In California, all original loans to purchase homes in  
          the state must be nonrecourse, but the status often changes to  
          recourse when the home is refinanced, or the borrower takes out  
          a second mortgage or a home equity line of credit.  In 2010, the  
          Legislature prohibited a lender from obtaining a deficiency  
          judgment for any first mortgage deficiency after a short sale of  
          a residence (SB 931, Ducheny).  In 2011, the Legislature  
          extended that treatment for all residential mortgages, including  
          second mortgages after a short sale (SB 458, Corbett).  

          4.   How does this work  ?  AB 99 doesn't apply to all short sales  
          or principal reductions, and doesn't forgive all kinds of debt  
          secured by a home.  Additionally, AB 99 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, AB 99 only applies to recourse loans, not  
               non-recourse ones, as discussed above.
                 Second, AB 99 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.  AB 99 does not forgive cancelled  
               debt incurred on investment or business property, or second  
               homes. 
                 Third, AB 99 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.








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                 Fourth, AB 99 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 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 AB 99 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)].  

          5.   A fine mess  .  California's lack of conformity with federal  
          law for debt forgiven in the 2014 taxable year, for debt  
          forgiveness has caused a significant degree of taxpayer  
          hardship.  Taxpayers with debt forgiveness income, were bound by  
          current law's lack of conformity in the 2014 taxable year, and  
          had to include the income in their returns filed before the  
          April 15th due date, or pay 90% of approximate tax amount when  
          filing an extension or face penalties.  While AB 99 would  
          address the income exclusion, it does so after the typical  
          filing deadline of April 15th.  As such, taxpayers will have to  
          file amended returns with a claim for refund of state taxes paid  
          based on including debt forgiveness income that weren't included  
          for federal taxes even if the Legislature enacts this measure.  

          6.   Fitting in  .  The Legislature last enacted an omnibus tax  








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          conformity bill in 2010, which conforms state tax law to the  
          Internal Revenue Code as of January 1, 2009.  After many years  
          out of conformity, the Assembly recently approved AB 154 (Ting),  
          which would change California's conformity date to January 1,  
          2015.  The Committee will likely hear the bill later this year.

          7.   Urgency  .  AB 99 is an urgency statute, and must be approved  
          by 2/3 vote of each house of the Legislature.












































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          Assembly Actions

           Assembly Floor                     80-0

          Assembly Appropriations            17-0
          Assembly Revenue and Taxation      9-0

           Support and  
          Opposition   (6/11/15)


           Support  :  Attorney General Kamal Harris, BOE Member George  
          Runner, California Association of Realtors, California Bankers  
          Association, California Credit Union League, California  
          Independent Bankers, California Mortgage Bankers Association,  
          California Society of Enrolled Agents, California Taxpayers  
          Association, and one individual.


           Opposition  :  Unknown.



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