BILL ANALYSIS Ó
SENATE COMMITTEE ON GOVERNANCE AND FINANCE
Senator Robert M. Hertzberg, Chair
2015 - 2016 Regular
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|Bill No: |SB 907 |Hearing |3/30/16 |
| | |Date: | |
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|Author: |Galgiani |Tax Levy: |No |
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|Version: |3/28/16 |Fiscal: |Yes |
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|Consultant|Grinnell |
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Personal income taxes: gross income exclusion: mortgage debt
forgiveness (URGENCY)
Extends California's modified conformity to federal law relating
to mortgage debt forgiveness.
Background
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, 2015 (AB 154, Ting, 2015).
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 generated a taxable gain. 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, such
as 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
(TIPA). Most recently, Congress enacted the Protecting
Americans from Tax Hikes (PATH) Act of 2015, which extended
forgiveness for two years, applying to discharges made on or
before December 31, 2016 year, and for discharges past that date
so long as the discharge was made pursuant to a written
agreement entered into before January 1, 2017.
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 made before January 1, 2014 (AB 1393, Perea, 2014),
but remains out of conformity for mortgage debt forgiven in 2014
because the Governor vetoed AB 99 (Perea, 2015), as well as for
discharges in 2015. The author wants to extend mortgage debt
forgiveness for the 2014 discharges, and conform to the PATH
Act's mortgage debt forgiveness provisions.
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Proposed Law
Senate Bill 907 extends California's modified conformity to the
Mortgage Forgiveness Debt Relief Act by excluding from income
for state tax purposes any discharge of qualified principal
residence indebtedness made between January 1, 2014 and January
1, 2017.
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 Franchise Tax Board (FTB), SB 907 results in
revenue losses of $95 million in 2015-16, $45 million in
2016-17, and $12 million in 2017-18.
Comments
1. Purpose of the bill . According to the author, "SB 907 would
extend the tax relief on forgiveness of mortgage debt by
conforming California law to the Federal Tax Increase Prevention
Act of 2014 and the Protecting Americans from Tax Hikes Act PATH
Act of 2015. 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 apply to the tax years: 2014, 2015,
and 2016."
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
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problems, but they have surely contributed to the almost $15.3
trillion in U.S. household debt, and $12.8 trillion in
non-financial business debt. SB 907 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
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. Recourse/non-recourse . 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 non-recourse, 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 ? SB 907 doesn't apply to all short sales
or principal reductions, and doesn't forgive all kinds of debt
secured by a home. Additionally, SB 907 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, SB 907 only applies to recourse loans, not
non-recourse ones, as discussed above.
Second, SB 907 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. SB 907 does not forgive cancelled
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debt incurred on investment or business property, or second
homes.
Third, SB 907 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.
Fourth, SB 907 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 SB 907 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. Veto . Last year, Governor Brown vetoed AB 99 (Perea), which
would have extended California's income exclusion for mortgage
debt forgiven in the 2014 year. Governor Brown vetoed the
measure using the same veto message that he issued for several
other bills, stating:
"Despite strong revenue performance over the past few
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years, the state's budget has remained precariously
balanced due to unexpected costs and the provision of new
services. Now, without the extension of the managed care
organization tax that I called for in special session, next
year's budget faces the prospect of over $1 billion in
cuts. Given these financial uncertainties, I cannot
support providing additional tax credits that will make
balancing the state's budget even more difficult. Tax
credits, like new spending on programs, need to be
considered comprehensively as part of the budget
deliberations."
6. A fine mess . California's lack of conformity with federal
law for debt forgiven in the 2014 and 2015 taxable years has
caused a significant degree of taxpayer hardship. While
excluded for federal purposes, taxpayers with debt forgiveness
income had to include the income in their returns filed before
the due date, or pay 90% of approximate tax amount when filing
an extension or face penalties. While SB 907 would address the
income exclusion, it does so after affected taxpayers have filed
2014 returns, and likely their 2015 ones too. As such,
taxpayers will have to file amended returns with a claim for
refund for state taxes paid based on including debt forgiveness
income which they never included for federal taxes should this
measure be enacted.
Support and
Opposition (3/24/16)
Support : Attorney General Kamala Harris, California Association
of Realtors, California Bankers Association, California Credit
Union League, California Mortgage Bankers Association,
California Reinvestment Coalition, California Taxpayers
Association, Center for Responsible Lending, Consumers Union,
Housing and Economic Rights Advocates.
Opposition : Unknown.
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