BILL ANALYSIS Ó
AB 2234
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Date of Hearing: April 18, 2016
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Sebastian Ridley-Thomas, Chair
AB 2234
(Steinorth) - As Introduced February 18, 2016
SUSPENSE
Majority vote. Fiscal committee.
SUBJECT: Personal income taxes: gross income exclusion:
qualified principal residence indebtedness
SUMMARY: Extends indefinitely, in modified conformity to
federal law, the tax relief for income generated from the
discharge of qualified principal residence indebtedness (QPRI).
Specifically, this bill:
1)Provides that the Internal Revenue Code (IRC) Section 108,
relating to income from discharge of QPRI, as amended by The
Protecting Americans from Tax Hikes Act of 2015 (Division Q of
Public Law 114-113), shall apply, except as otherwise
provided.
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2)Applies discharges to QPRI occurring on or after January 1,
2014.
3)Provides that, notwithstanding any other law, no penalties or
interest shall be due to the discharge of QPRI for the 2014 or
2015 taxable year, regardless of whether or not a taxpayer
reports the discharge during the 2014 or 2015 taxable year.
4)Makes findings and declarations stating that the retroactive
application of this bill is necessary for the public purpose
of preventing undue hardship to taxpayers whose QPRI was
discharged on and after January 1, 2014, and before January 1,
2016, and does not constitute a gift of public funds.
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
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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
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, 2017.
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 COD.
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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 part 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.
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 years or more. The
amount of gain eligible for the exclusion is $250,000
(taxpayers filing a single return) or $500,000 (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.
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b) The maximum amount of QPRI is limited to $800,000
($400,000 for a married/RDP individual filing a separate
return).
c) For discharges occurring in 2007 or 2008, the total
amount of non-taxable COD income is limited to $250,000
($125,000 for 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 a
married/RDP individual filing a separate return).
2)Requires individual taxpayers to pay their estimated
California income tax in four installments over the taxable
year, and 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 for
discharge of QPRI regardless of whether the discharge is
reported on the income tax return.
FISCAL EFFECT: The Franchise Tax Board (FTB) estimates an
annual revenue loss of $95 million in fiscal year (FY)
2015-2016, $50 million in FY 2016-2017, and $46 million in FY
2017-2018.
COMMENTS:
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1)Author's Statement : The author provided the following
statement in support of this bill:
AB 2234 removes an unnecessary impediment to financial
independence for troubled homeowners. Those who have lost
their homes or are struggling to pay their mortgages should
not be subject to additional taxes. California's recovery
from the recession remains sluggish and homeowners are
still getting back on their feet. We can help that
recovery by allowing them to keep more of their hard-earned
income during such a critical time. This legislation
provides relief to these families in the hope they are able
to stabilize their financial situation. In addition, it
will end the ongoing uncertainty caused by the piecemeal
renewal of the income exclusion.
2)Arguments in Support : Proponents of this bill state that the
Federal Government extended the tax treatment of forgiven
mortgage debt for the 2015 and 2016 tax years, so "by
conforming to federal law, both restoratively for the 2014 and
the 2015 tax years, AB 2234 eliminates a significant
impediment for homeowners seeking viable alternatives to
foreclosure during these tough economic times."
3)Mortgage Debt Forgiveness : 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,
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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. On December 18, 2015, the Federal Government enacted
the Protecting Americans from Tax Hikes Act of 2015 and again
extended, for two additional years, the exclusion from gross
income for COD generated from the discharge of QPRI.
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
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
obtained 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. 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
---------------------------
<1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).
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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. Existing law, however, provides several exceptions to
the general rule, for example allowing a taxpayer to exclude
COD income from his/her gross income if the debt is discharged
in Title 11 bankruptcy, if he/she is insolvent immediately
before the debt is cancelled, or if it is non-recourse debt.
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 as the entire amount
of the nonrecourse debt is treated as an amount realized on
the disposition of the property.
However, when a lender agrees to decrease the amount of the
original debt to reflect the current value of the property
secured by the debt, the cancellation of non-recourse debt
without a transfer of the property, such as in foreclosure,
creates COD income for the taxpayer. Consequently, this bill
would continue to provide relief to a solvent California
homeowner who refinanced the first mortgage or obtained a home
equity loan or a home equity line of credit. This bill will
also continue to provide 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.
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6)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 the 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
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
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increased. As of February 2016, California's unemployment
rate stood at 5.5%, almost seven percentage points lower than
its post-recession peak of 12.0%. (Employment Development
Department, Historical Civilian Labor Force, California, March
2016.) Additionally, the number of seriously "underwater"
homes went from a peak of 12.8 million in 2012 to just 6.9
million in the third quarter of 2015. The substantial
reduction in underwater homes has primarily been triggered by
a 35% increase in the national median home value since
bottoming out in 2012, and a recent dramatic pick up in home
sales volume and average sales price. (RealtyTrac, Number of
Seriously Underwater Properties Drops 525,000 in Q3 2015 From
Previous Quarter, Down 1.2 Million From Year Ago, October 21,
2015.) In light of substantial improvements to the economy,
the Committee may wish to consider whether an indefinite
extension of the exclusion for COD generated from the
discharge of QPRI is warranted.
7)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, 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.
8)Importance of Federal Conformity : This bill not only conforms
the exclusion from gross income for COD generated from the
discharge of QPRI to federal law for discharges occurring
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before January 1, 2017, but indefinitely excludes COD
indefinitely in future years, even if no federal exclusion is
provided. Conformity with federal law reduces taxpayer errors
and eases tax filing and administration. Although the federal
exclusion has been extended to include every year since 2007,
there is no guarantee that it will be continued past 2017.
The Committee may wish to consider whether state mortgage
forgiveness debt relief should apply in years when a similar
federal exclusion is not provided.
9)Technical Amendments : On Page 2, Line 8, strikeout "2015" and
insert "2017".
Additionally, the FTB has proposed the following technical
amendments:
On Page 2, Line 21, strikeout "2007 or 2009" and insert "2007,
2009, or 2013";
On Page 2, Line 23, strikeout "2007 or 2009" and insert "2007,
2009, or 2013";
On Page 2, strikeout Lines 24 through 34, inclusive;
On Page 2, Line 35, strikeout "(f)" and insert "(d)";
On Page 2, Line 35, strikeout "adding" and insert "amending".
10)Related Legislation : SB 907 (Galgiani) would extend the
state exclusion of mortgage forgiveness debt relief to
discharges occurring in 2014, 2015, and 2016, and would
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provide that no penalties or interest would be imposed on
discharges occurring in 2014 or 2015. SB 907 is pending
hearing by the Senate Committee on Appropriations.
11)Prior Legislation : AB 99 (Perea), of the 2015-2016
Legislative Session, would have extended California's modified
conformity to the Mortgage Forgiveness Debt Relief Act for
discharges of QPRI until January 1, 2015. AB 99 was vetoed.
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.
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.
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.
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.
SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the PIT
Law to conform to the federal extension of mortgage
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forgiveness debt relief provided in the Emergency Economic
Stability Act, with the following modifications: (a) it
applies to discharges occurring in 2009, 2010, 2011, and 2012
tax years; (b) 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; (c) 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, (d) interest and penalties are not
imposed with respect to discharges that occurred in the 2009
taxable year.
REGISTERED SUPPORT / OPPOSITION:
Support
California Association of Realtors
California Bankers Association
California Credit Union League
California Mortgage Bankers Association
California Taxpayers Association
Opposition
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None on file
Analysis Prepared by:Irene Ho / REV. & TAX. / (916) 319-2098