BILL ANALYSIS Ó
SB 907
Page A
(Without Reference to File)
SENATE THIRD READING
SB
907 (Galgiani)
As Amended June 23, 2016
2/3 vote. Urgency
SENATE VOTE: 39-0
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|Committee |Votes|Ayes |Noes |
| | | | |
| | | | |
| | | | |
|----------------+-----+----------------------+--------------------|
|Revenue & |9-0 |Ridley-Thomas, | |
|Taxation | |Brough, Dababneh, | |
| | |Gipson, Mullin, | |
| | |O'Donnell, Patterson, | |
| | |Quirk, Wagner | |
| | | | |
| | | | |
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SUMMARY: Extends the tax relief for income generated from the
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discharge of qualified principal residence indebtedness (QPRI).
Specifically, this bill:
1)Provides that Internal Revenue Code (IRC) Section 108,
relating to income from discharge of QPRI, as amended by the
Tax Increase Prevention Act (TIPA) of 2014 and the Protecting
Americans from Tax Hikes (PATH) Act of 2015, shall apply,
except as otherwise provided.
2)Applies to discharges of QPRI occurring on or after January 1,
2014, and before January 1, 2017, and discharges of QPRI on or
after January 1, 2017, if the discharge is pursuant to an
arrangement entered into and evidenced in writing prior to
January 1, 2017.
3)Provides that, notwithstanding any other law, no penalties or
interest shall be owed due to the discharge of QPRI for the
2014 or 2015 taxable years, regardless of whether or not a
taxpayer reported the discharge during the 2014 or 2015
taxable years.
4)Makes findings and declarations stating that the retroactive
application of this bill is necessary for the public purpose
of conforming state law to federal law, thereby preventing
undue hardship to taxpayers whose QPRI was discharged on or
after January 1, 2014, and before January 1, 2016, and does
not constitute a gift of public funds.
5)Takes immediate effect as an urgency statute necessary for the
immediate preservation of the public peace, healthy, or safety
within the meaning of Article IV of the California
Constitution.
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EXISTING FEDERAL LAW:
1)Includes in the gross income of a taxpayer any 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
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 cases 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, and on or after January 1, 2017, if the discharge is
pursuant to an arrangement entered into and evidenced in
writing prior to January 1, 2017.
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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 the COD.
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 of 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.
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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.
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 COD income
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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 years for
discharge of QPRI regardless of whether the discharge is
reported on the income tax return.
FISCAL EFFECT: According to the Assembly Appropriations
Committee, annual General Fund revenue loss of $95 million, $45
million, and $12 million in 2015-16, 2016-17, and 2017-18,
respectively.
COMMENTS:
1)Mortgage Debt Forgiveness: SB 1055 (Machado), Chapter 282,
Statutes of 2008, provided modified conformity to the Mortgage
Forgiveness Debt Relief Act (MFDRA) for the discharge of
mortgage indebtedness in 2007 and 2008 tax years. SB 401
(Wolk), Chapter 14, Statutes 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 a taxpayer's gross income from $250,000
($125,000 in case of married individual/RDP filing a separate
return) to $500,000 ($250,000 in case of married
individual/RDP filing a separate return). On January 2, 2013,
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
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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. AB 1393 (Perea), Chapter
152, Statutes of 2014, similarly extended California's
modified conformity to the MFDRA for discharges of QPRI for
one additional taxable year.
On December 19, 2014, the Federal Government enacted TIPA 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. AB 99 (Perea), of the 2015-16 Legislative Session,
would have similarly extended California's modified conformity
to the MFDRA for discharges of QPRI for one additional taxable
year, but was vetoed. On December 18, 2015, the Federal
Government enacted the PATH Act and again extended, for two
additional taxable years, the exclusion from gross income for
COD generated from the discharge of QPRI , and also applied
the exclusion to discharges of QPRI on or after January 1,
2017, if the discharge is pursuant to an arrangement entered
into and evidenced in writing prior to January 1, 2017.
2)Why is COD Taxable? Most individuals find the idea of taxing
debt cancellation counterintuitive, 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. In 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.
---------------------------
<1>
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
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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
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.
3)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
securing the debt, the cancellation of non-recourse debt
without a transfer of the property, such as in foreclosure,
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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.
4)Why Exclude COD from Gross Income? Despite the economics of
taxing COD, the rationale for excluding cancelled mortgage
debt 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 debt 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
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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
increased. As of April 2016, California's unemployment rate
stood at 5.3%, almost seven percentage points lower than its
post-recession peak of 12.0%. (Employment Development
Department, Historical Civilian Labor Force, California, May
2016.) Additionally, the number of seriously "underwater"
homes went from a peak of 12.8 million in 2012 to just 6.7
million in the first quarter of 2016, triggered by escalating
property values. (RealtyTrac, Less Than One Percent of
Seriously Underwater U.S. Properties Qualify for Principal
Reduction Under New FHFA Program, May 4, 2016.) In light of
substantial improvements to the economy, it is unclear whether
extending the exclusion for COD income generated from the
discharge of QPRI is still warranted.
5)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
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personal consumption.
Analysis Prepared by:
Irene Ho / REV. & TAX. / (916) 319-2098 FN:
0005031