BILL ANALYSIS Ó AB 1736 Page 1 Date of Hearing: May 9, 2016 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Sebastian Ridley-Thomas, Chair AB 1736 (Steinorth) - As Amended May 3, 2016 Majority vote. Fiscal committee. Tax levy. SUBJECT: Personal income taxes: deduction: homeownership savings accounts SUMMARY: Creates a homeownership savings account (HSA) under the same rules as apply to the Individual Retirement Account (IRA) and allows a deduction for contributions made by qualified individuals to the HSA, as specified. Specifically, this bill: 1)Allows a deduction equal to the amount contributed in the HSA by a qualified taxpayer in any taxable year commencing on or after January 1, 2017, not to exceed: a) $20,000 for qualified taxpayers who are married filing a joint return, a head of household and surviving spouses, as defined. b) $10,000 for qualified taxpayers filing a return other than those specified. AB 1736 Page 2 2)Defines a "Homeownership Savings Account" as a trust that meets all of the following requirements: a) Is designated as a HSA by the trustee; b) Is established for the exclusive benefit of any qualified taxpayer establishing the account where the written governing instrument creating the account provides for the following: i. All contributions to the account are required to be in cash; and ii. The account is established to pay, pursuant to applicable requirements and limitations, for the qualified homeownership savings expenses of a qualified taxpayer establishing the account. c) Is, except as otherwise provided, subject to the same requirements and limitations as an IRA established under Section 408 of the Internal Revenue Code, relating to individual retirement accounts, and any regulations adopted thereunder. d) Is established by a qualified taxpayer who has a gross income of 80 percent or less than the area median income. e) Is the only homeownership savings account established by the qualified taxpayer. AB 1736 Page 3 3)Excludes from gross income, for each taxable year beginning on or after January 1, 2017, any income accruing to a HSA during the taxable year. 4)Specifies that any withdrawals for other than qualified expenses shall be included in income of the payee or distributee for the taxable year in which the payment or distribution is made, unless the payment or distribution is used to pay for the homeownership savings expenses of a qualified taxpayer who established the account. 5)Defines a "qualified homeownership savings expense" as expenses, including a down payment or closing costs, paid or incurred in connection with the purchase of a qualified taxpayer's principal residence in California for use by that taxpayer who established the HSA. 6)Defines a "qualified taxpayer" as any individual, or individual's spouse, who has never had an ownership interest in a principal residence subject to the contribution allowed by this section. 7)Provides that the term "trustee" has the same meaning as it has under Section 408 of the IRC, relating to traditional IRAs. 8)Takes effect immediately as a tax levy. EXISTING FEDERAL LAW: AB 1736 Page 4 1)Provides for two types of IRAs: traditional IRAs and Roth IRAs. Limits the amount of qualified contributions to both traditional and Roth IRAs to the smaller of $5,500 ($6,500 for taxpayers 50 years of age or older), or the taxpayer's taxable compensation for the year. 2)Allows an income tax deduction for contributions (other than a rollover contribution) made only to a traditional IRA. Contributions made a Roth IRA are subject to tax. 3)Provides that amounts held in a traditional IRA are generally included as income when withdrawn, except to the extent the withdrawal is a return of nondeductible contributions. Withdrawals are subject to an additional tax of 10% if withdrawn prior to age 59 , with some exceptions. Specifically, the taxpayer is not subject to the early withdrawal tax if the withdrawal is used for first-time homebuyer expenses of up to $10,000. 4)Allows an exclusion from gross income for any qualified distribution from a Roth IRA. 5)Allows various deductions and exclusions in computing taxable income and provides that an individual may elect to claim itemized deductions for a taxable year in lieu of the standard deduction. EXISTING STATE LAW: 1)Provides that federal changes to Part I of Subchapter D of Chapter 1 of IRC Sections 401 through 420, inclusive, relating to pension, profit-sharing, stock bonus plans, other employee benefit plans, and IRC Section 457, relating to deferred AB 1736 Page 5 compensation plans of state and local governments and tax-exempt organizations, automatically apply without regard to taxable years to the same extent as applicable for federal income tax purposes. All federal changes made to those IRC sections are automatically adopted by California without regard to the specified date. 2)Provides that a distribution from a 401(k) plan, a qualified annuity plan under IRC Section 403(a), a tax-sheltered annuity under IRC Section 403(b), an eligible deferred compensation plan under IRC Section 457, or an individual retirement arrangement under IRC Section 408 is included in income for the year distributed. 3)Imposes a penalty equal to 2%, instead of the federal rate of 10%, of the amount includible in income on early withdrawals from those plans, unless an exemption applies, in conformity with the federal tax law. 1)Allows various deductions and exclusions in computing taxable income under the Personal Income Tax (PIT) law and generally conforms to the federal rules that apply to itemized deductions. 2)Specifies that the California Housing Finance Agency (CalHFA) may provide down payment assistance in the form of deferred payment, low-interest, and junior mortgage loans, which are designed to reduce principle and interest payments to make financing affordable for first time low and moderate income homebuyers. In most cases, CalHFA programs may be used in conjunction with other first-time homebuyer programs, including programs offered by nonprofit entities. AB 1736 Page 6 FISCAL EFFECT: The Franchise Tax Board (FTB) staff estimates that this bill will result in an annual revenue loss of $220 million in the fiscal year (FY) 2017-18 and $450 million in FY 2018-19. COMMENTS: 1)Author's Statement . The author has provided the following statement in support of this bill: "The dream of owning a home is the foundation our middle class is built on. I am firmly committed to keeping that dream alive. AB 1736 presents an innovative solution to enable first-time homebuyers to save more of their hard-earned money and put it towards their very first home. The benefits of homeownership are clear, and this bill will make those benefits more attainable for families across California. In turn, the state will be able to retain more workers and businesses alike, and encourage the construction of more needed homes." 2)Agreements in suppor t: According to the Building Industry Association, data recently released by Beacon Economic shows California ranks 49th in homeownership and last in overall housing affordability. "While an average California home cost $440,000, homebuyers need additional tools to attain the American Dream. As the state grapples with a housing affordability crisis, AB 1736 will allow first-time homebuyers to save more of their own money in order to attain the benefits of homeownership." 3)Arguments in Opposition : According to the California Tax Reform Association, "This bill provides little or no help to those struggling to buy a home in California's expensive AB 1736 Page 7 housing market. By allowing a deduction, it provides the greatest benefits to those who are better off, that is, are in the higher tax brackets in our progressive tax system. In fact, since it has no income limitation it merely provides a tax shelter for those with substantial income, but even with such a limitation it would still provide disproportion benefits to the well-off who can save the most and are at least in need of help in buying a home. " 4)Tax-Advantaged Savings Accounts and Retirement Plans . Congress has authorized several kinds of retirement savings plans that qualify for reduced or deferred income taxes to encourage workers to save for retirement. A qualified retirement plan, such as a 401(k) plan or an IRA, allows a worker to save for retirement by investing a portion of his/her wages while deferring current income taxes on the original investment and earnings until withdrawal. All qualified contributions are invested on a pre-tax basis and not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in qualified IRA plans may elect to deposit some or all of their wages in a designated brokerage account, commonly known as a Roth IRA. Qualified distributions from a designated Roth account are tax free, while contributions are made on an after-tax basis (i.e., income tax is paid or withheld on the contributions in the year contributed). 5)Exceptions to the Early Withdrawal Penalty . Existing federal tax law imposes a 10% withdrawal penalty on early distributions made from a qualified retirement or annuity plan, a 403(b) annuity, or an IRA to a taxpayer under the age of 59, unless an exception applies. California imposes a similar penalty but at the rate of 2% of the amount includible in income on early withdrawals from those plans. However, recognizing that some significant events might require people to withdraw money from their retirement AB 1736 Page 8 accounts earlier than expected, Congress has provided for a waiver of the early withdrawal penalty in some situations, to which California has conformed. An exception applies to distributions that are (a) used for the health insurance premiums of an unemployed individual (in the case of IRA distributions only); (b) used for medical expenses; (c) made to a beneficiary (or to the estate of the employee) on or after the date of the employee's death; (d) made to an employee who separates from service at age 55 or older; (e) made to individuals called to active duty; or (f) used for first-time home purchases (in the case of IRA distributions only). 6)The "First-Time Home Buyer" Exception . Both federal and state laws already authorize penalty-free withdrawals of a limited amount of IRA funds for first-time homebuyers. The definition of "first-time homebuyer" is broad and includes not only to the taxpayer's very first home purchase, but also applies in the case of a taxpayer whose spouse has not owned a principal residence at any time during the past two years even if the taxpayer himself/herself would not qualify as the first home buyer. Furthermore, a taxpayer does not have to purchase the residence for himself/herself. The taxpayer may also qualify for the exemption if he/she is helping his/her child, grandchild or parent to buy a home. In the case of a traditional IRA, the maximum amount of IRA funds that may be withdrawn without the penalty is $10,000. In the case of a Roth IRA, this limitation applies only to the amount of earnings withdrawn from the account because one can always withdraw his/her contributions to a Roth tax- and penalty-free. The $10,000 limitation applies on an individual basis, which means that both the taxpayer and his/her spouse may qualify individually for the homebuyer exemption, potentially doubling the amount of money they can withdraw AB 1736 Page 9 from IRA accounts. In light of the existing waiver under both federal and state laws allowing a penalty-free distribution of funds from qualified individual retirement accounts, the Committee may wish to consider whether this bill is necessary. 7)High-Income Taxpayers Benefit More Than Low-Income Taxpayers . The proposed deductions for contributions to HSAs would disproportionately benefit taxpayers in higher tax brackets because the "value" of a deduction varies with the marginal tax rate (or tax bracket) of the taxpayer. Thus, when a taxpayer who is in the 30% tax bracket deducts a $100 contribution, his/her tax is reduced by $30. On the other hand, if the taxpayer is in a 20% bracket, a $100 contribution deducted from his/her gross income would reduce his/her tax liability only by $20. Because of the progressive rate structure of the tax system, taxpayers in higher tax brackets benefit more from income deductions than individuals in lower tax brackets. This effect is magnified in the case of HSAs: a higher income taxpayer, with presumably a greater ability to purchase a house, would receive a greater tax benefit than the lower income taxpayer. 8)Existing Tax Incentives for Homeowners . Existing law heavily subsidizes owner-occupied housing. Tax preferences that encourage homeownership include: deductibility from income of mortgage interest on first and second homes for state and federal purposes; deductibility from income of property taxes for state and federal tax purposes; and exclusion from income of certain capital gains on the sale of a home for state and federal tax purposes. For example, taxpayers may deduct interest payments on up to $500,000 single/$1 million joint of indebtedness used to purchase a first and second home. Taxpayers may also deduct interest payments on up to $100,000 in home improvement loans. In addition, taxpayers may exclude up to $250,000 single/$500,000 joint in income resulting from AB 1736 Page 10 the sale of their principal residence. The Department of Finance estimates that these tax benefits resulted in more than $7.2 billion in foregone revenue in fiscal year (FY) 2014-15. Homeownership is also encouraged by the non-taxability of the housing services that are received by the owner. In fact, according to the Congressional Research Service report, some analysts argue that this preferential tax treatment encourages households to over-invest in housing and invest less in business investments that might contribute more to the nation's productivity and output. 9)Tax Expenditures . Each year, more and more interest groups are seeking ways to increase funding through alternative means, such as tax credits and other tax incentives. However, as the Department of Finance notes in its annual Tax Expenditure Report, there are several key differences between tax expenditures and direct expenditures. First, tax expenditures are reviewed less frequently than direct expenditures once they are put in place, which can offer taxpayers greater certainty but can also result in tax expenditures remaining a part of the tax code in perpetuity without demonstrating any public benefit. Second, there is generally no control over the amount of revenue losses associated with any given tax expenditure. Finally, it generally takes a two-thirds vote to rescind an existing tax expenditure. This effectively results in a "one-way ratchet" whereby tax expenditures can be conferred by majority vote, but cannot be rescinded, irrespective of their efficacy, without a supermajority vote. 10)Tax Subsidy vis-à-vis Grant Program: Is the Tax Code the Best AB 1736 Page 11 Way to Subsidize Homeownership? Although well intentioned, this bill represents an attempt to use the tax code to accomplish a public policy objective that may be more efficiently addressed through a direct outlay of state funds. This bill proposes a tax subsidy to taxpayers to help them achieve the dream of homeownership. The FTB staff estimates that this bill would eventually result in an annual GF revenue loss of $450 million. As discussed in the Housing and Community Development Committee's analysis of this bill, the California Housing Finance Agency (CalHFA) operates the California Homeowner Downpayment Assistance Program (CHDAP) and provides homebuyers between 3% and 6% in downpayment assistance secured as a second mortgage on the home. The program operates as a revolving loan; when a home is sold, CalHFA is repaid allowing the funds to go to another homebuyer. There is approximately $150 million available in CHDAP at this time. The program can provide downpayments to individuals that make up to 120% of the area median income (AMI) and just recently raised its income limits to 140% of AMI in high-cost areas. CalHFA operates independently of the state General Fund and derives the funding for its downpayment assistance program from the sale of bonds. The Committee may wish to consider whether expanding the CHDAP program to include more homebuyers would be a better vehicle to subsidize homeownership. Alternatively, given the shortage of affordable housing in California, the Committee may wish to consider whether a priority should be given to affordable housing, rather than individual homeownership. 11)Double Benefit . This bill would allow taxpayers to make tax-deductible contributions to, and receive tax-free withdrawals from, a HSA as long as the funds are used for qualified expenses. In contrast, a traditional IRA allows tax-deductible contributions, but imposes a tax on distributions. And while qualified distributions from Roth IRAs are tax-free, contributions to these accounts are taxable. The Committee may wish to consider whether this AB 1736 Page 12 preferential tax treatment of savings for homeownership, but not retirement, is justified and whether either the contributions to, or distributions from, an HSA should be taxable. 12)Lack of Conformity . Conformity with federal law reduces taxpayer errors and eases tax filing and administration. This bill would create a state and federal difference, which adds complexity to the tax return as the income excluded or deferred by this bill is still subject to federal income tax. In the absence of similar federal treatment, taxpayers and banks will need to keep separate accounting of the deposits and withdrawals for state and federal tax purposes. 13)Absence of a Sunset Date : In its current form, this bill's proposed tax expenditure lacks an automatic sunset provision. This Committee has a longstanding policy favoring the inclusion of sunset dates to allow the Legislature periodically to review the efficacy and cost of such programs. The author may wish to consider the addition of an appropriate sunset provision. 14)Definition of "Qualified Taxpayer ." This bill defines a "qualified taxpayer" as an individual or his/her spouse that has never had an ownership interest in a principal residence subject to the contribution allowed by this section. It is unclear to Committee staff whether this definition is intended to apply to individuals who have never owned a principal residence in their lives or to individuals who have never used HSA moneys to purchase a principal residence. The Committee may wish to consider limiting the application of this bill only to the former category of individuals. AB 1736 Page 13 15)Double Referred : This bill was referred to both the Assembly Committee on Housing and Community Development and this Committee. This bill passed the Committee on Housing and Community Development with amendments on 7-0 vote. REGISTERED SUPPORT / OPPOSITION: Support California Building Industry Association California Council for Affordable Housing County of San Bernardino Habitat for Humanity California League of California Cities Western Manufacturing Housing Communities Association Opposition AB 1736 Page 14 None on file Analysis Prepared by:Oksana Jaffe / REV. & TAX. / (916) 319-2098