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 |
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|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.
AB 99 (Perea) 5/20/15
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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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