BILL ANALYSIS
AB 111
Page 1
Date of Hearing: May 4, 2009
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Charles M. Calderon, Chair
AB 111 (Niello) - As Amended: March 31, 2009
REVISED
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Taxation: cancellation of indebtedness: mortgage
debt forgiveness.
SUMMARY : Allows a solvent individual taxpayer to exclude from
his/her gross income an amount of qualified principal residence
indebtedness (QPRI), up to $2 million, discharged by the lender
on or after January 1, 2009 and before January 1, 2013, in full
conformity with the federal income tax law. Specifically, this
bill :
1)Conforms the Personal Income Tax (PIT) Law to the federal Act
of 2007 [Public Law (P.L.) 110-142], as extended by Section
303 of the Emergency Economic Stabilization Act of 2008 (P.L.
110-343), to allow an exclusion from gross income for
cancellation of indebtedness (COD) income generated from the
discharge of QPRI.
2)Contains legislative findings and declarations stating that
the mortgage debt tax relief allowed to taxpayers in
connection with the discharge of QPRI serves a public purpose,
and does not constitute a gift of public funds.
3)Takes effect immediately as a tax levy.
EXISTING FEDERAL LAW :
1)Includes in gross income of a taxpayer an amount of debt that
is discharged by the lender (known as 'cancellation of debt'
or COD), except for any of the following debts:
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
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taxpayer's total debts exceeds the fair market value of the
taxpayer's total assets;
c) Certain farm debts and student loans; or,
d) Debt discharge 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. [Internal
Revenue Code (IRC) Section 108].
2)Requires a taxpayer to reduce certain tax attributes by the
amount of the discharged indebtedness in the case where that
indebtedness is excluded from the taxpayer's gross income.
(IRC Section 108).
3)Excludes from the gross income of a taxpayer any COD income
that resulted from a discharge of QPRI occurring on or after
January 1, 2007, and before January 1, 2013. (P.L. 110-12,
Section 2, and P.L. 110-343, Section 303).
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; or single
taxpayers 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 if
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
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it exceeds the portion 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. An
amount of gain eligible for the exclusion is $250,000
(taxpayers filing single) or a $500,000 (for 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) The exclusion applies to discharges of QPRI that
occurred on or after January 1, 2007 and before January 1,
2009;
b) The maximum amount of QPRI is reduced to $800,00
($400,000 in the case of a married/registered domestic
partner (RDP) individual filing a separate return); and,
c) The total amount of COD income excluded is limited to
$250,000 ($125,000 in the case of 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. Imposes a penalty for the underpayment of estimated
tax, which is the difference between the amount of tax shown
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on the return for the taxable year and the amount of estimated
tax paid.
3)Waives the underpayment of estimated tax penalty if the tax
liability is less than $500, there was not tax liability in
the prior taxable year, or total withholding plus estimated
tax payments total 90% of the tax shown on the current year
return or 100% (or 110% for higher income taxpayers) of the
tax shown on the prior year's return.
4)No interest or penalties are imposed on discharges of QPRI
that occurred during the 2007 taxable year.
FISCAL EFFECT : The Franchise Tax Board staff estimates that
this bill will result in an annual revenue loss of $9.4 million
in fiscal year (FY) 2009-10, $8.7 million in FY 2010-11, and
$6.7 million in FY 2011-12.
COMMENTS :
1)The author states that, "AB 111 is necessary to fully conform
to federal provisions that offer tax relief to displaced
homeowners. Currently, forgiven mortgage debt is recognized
as income for personal tax purposes in California. In light
of the mortgage foreclosure crisis, Congress has suspended
this requirement until January 1, 2012. We must act similarly
to avoid handing huge tax bills to displaced homeowners."
2)The proponents of this bill state that, from a California tax
policy perspective, conformity with federal tax laws provide
fairness and simplification, and eases the burden of tax
compliance, which in turn eases taxpayer compliance costs.
The proponents also argue that the prospect of taxation of
"phantom" income acts as a substantial disincentive to short
sales and this bill is important because it addresses a
significant impediment for homeowners seeking viable
alternatives to foreclosure. Some proponents also believe
that AB 111 would help California's current mortgage market
situation and ailing economy.
3)Committee staff notes all of the following:
a) Why is COD income taxable to a taxpayer ? While the idea
of taxing COD income is counterintuitive to most people,
the economic theory behind existing law is sound tax policy
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in that it reflects the fact that a person's net worth is
increased if his/her debt is cancelled. Under existing
law, a loan amount is not includible in the borrower's
gross income; however, when the borrower repays the loan,
no deduction is allowed to the borrower for the repayment
of the principal amount of the loan. In other words,
because the borrower repays with after-tax dollars, the
amount of repayment is effectively taxed in the year of
repayment. If income is defined as a change in a person's
net worth then, by definition, a forgiven loan is income
because a cancelled debt reduces a taxpayer's liabilities,
and thus, increases his/her net worth. As noted by Debora
A. Greier, a Professor of Law of Cleveland State
University, in her statement before the United States
(U.S.) Senate Committee on Finance, without this tax rule
to account for the forgiveness and non-repayment of the
loan, "the borrower will have received permanently tax-free
cash in the year of original receipt", i.e. the year in
which the borrower received the loan.
For example, assume that a taxpayer borrowed $100,000. After
repaying $80,000 of the $100,000 borrowed, the taxpayer
gets discharged from the remaining debt. The taxpayer has
COD income of $20,000 because he/she now has $20,000 worth
of assets available to use for other purposes that were
previously committed (at least, on the balance sheet) to
repaying the loan.
b) Exceptions to COD income recognition . Existing law,
however, provides several exceptions to the general rule.
Thus, a taxpayer may exclude COD income from his/her gross
income if the debt is discharged in Title 11 bankruptcy.
If the debt is not discharged in bankruptcy, the taxpayer
may exclude the COD income if he/she is insolvent, i.e. the
taxpayer's liabilities exceed the fair market value of
his/her assets, determined immediately prior to discharge.
Both exceptions, however, are, in essence, deferral
provisions because they require a taxpayer to reduce
certain beneficial tax attributes, including the taxpayer's
basis in property that would otherwise decrease the
taxpayer's income or tax liability in future years. Other
exceptions include COD income generated by a cancellation
of "non-recourse" debt and a cancellation of debt that was
intended to be a gift or was the result of a disputed debt.
A non-recourse loan is a loan for which the lender's only
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remedy in the case of default is to repossess the property
being financed or used as collateral. That is to say that
the borrower is not personally liable for the debt and the
lender cannot pursue the homeowner personally in the case
of default. For the 2007 and 2008 tax years only,
California law allowed a taxpayer to exclude from his/her
gross COD income that resulted from a discharge of QPRI, up
to $250,000. [SB 1055 (Machado/Correa), Chapter 282,
Statutes of 2008].
c) Non-recourse Debt . 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.
However, even a taxpayer with non-recourse debt must pay
tax on the COD income realized from a reduction of that
debt, or part thereof, when a lender agrees to decrease the
amount of the original debt to reflect the current value of
the property secured by the debt, because a cancellation of
non-recourse debt without a transfer of the property
creates COD income for the taxpayer in an amount equal to
the amount cancelled by the lender. Consequently, this
bill would provide relief to a solvent California homeowner
who refinanced the first mortgage or took out a home equity
loan or a home equity line of credit. It will also 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.
d) Solvent Taxpayers . Because this bill applies to solvent
taxpayers, the question arises as to whether the solvent
taxpayer deserves the tax relief that is usually afforded
only to insolvent taxpayers. As outlined by Debora A.
Greier in her statement before the U.S. Senate Committee on
Finance, existing tax law treats personal residences as
personal use assets providing personal consumption, and
therefore, personal residences are not depreciable and
losses on sale of those properties are not deductible. In
fact, tax law "assumes that any loss in value of a personal
residence is due to personal consumption rather than market
forces unrelated to the taxpayer's consumption". However,
it appears that currently, because of the unusual housing
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market conditions, in many cases, the loss in value of a
personal residence is attributable to market conditions,
similar to investment property, and not due to any personal
consumption of the taxpayer. Consequently, Debora A.
Greier concludes that the only way for tax law to measure
properly this taxpayer's wealth is to exclude COD income
from the taxpayer's gross income, provided that the
exclusion is a temporary measure necessary to address the
unusual market conditions.
e) Public policy for excluding COD income from gross
income . From a public policy perspective, a rationale given
for excluding canceled mortgage debt income has focused on
minimizing hardship for households in distress and ensuring
that homeownership retention efforts are not thwarted by
tax policy. In fact, some analysts anticipate a new wave
of mortgage interest-rate resets in 2009 and 2010,
including resets in prime loans given to people with good
credit.
Some argue that the exclusion of canceled residential debt
income is necessary to prevent unintended adverse
consequences resulting from foreclosure prevention efforts
especially, as lenders are being encouraged to write-down,
or work out, loans with distressed borrowers. Another
stated purpose is to prevent a reduction of consumer
spending by already financially distressed households in
the wake of foreclosures and housing market disruptions.
[See, e.g. Congressional Research Service's report (CRS
report) entitled 'Analysis of the Proposed Tax Exclusion
for Cancelled Mortgage Debt Income', dated January 8, 2008,
p. 10]. The opponents of the COD exclusion argue that it
may make debt forgiveness more attractive for homeowners
relative to the current tax law and may encourage
homeowners to be less responsible about fulfilling their
debt obligations.
f) QPRI includes secondary loans . This bill applies to COD
income realized by the taxpayer from the cancellation of
indebtedness 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.
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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. This
bill 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.
g) Temporary Relief . This bill limits the tax relief only
to COD income that is realized on or after January 1, 2009
and before January 1, 2013, with respect to the taxpayer's
primary residence, to the extent of $2 million ($1 million
in the case of a married taxpayer filing separately).
However, California already provided a similar exemption,
albeit more limited, for discharges of QPRI that occurred
in the 2007 and 2008 tax years. The maximum amount of QPRI
was $800,000 ($400,000 in the case of a married/RDP
individual filing a separate return), and the total amount
of COD income excluded was limited to $250,000 ($125,000 in
the case of a married/RDP individual filing a separate
return).
h) Should the amount of QPRI be increased from $800,000 to
$2 million ? While appreciating both the tax and public
policy objectives advanced for the enactment of the federal
Act of 2007, as amended by P.L. 110-343, the Committee
staff questions the amount of QPRI that is eligible for the
exclusion allowed by this bill. The proposed $2 million
limitation on the amount of QPRI eligible for exclusion is
much more than all but the most affluent homeowners need in
hardship assistance from the state. Generally, QPRI means
debt incurred in the acquisition, construction, or
substantial improvement of the principal residence of the
individual and secured by the residence. According to
DataQuick Information Systems, a research firm, the median
home price in California was $484,000 in March 2007, when
the market peaked. Even the highest median price of a
house in Marin County in 2007 ($871,000) was well below the
proposed QPRI maximum of $2 million. Given that the median
price of a house in most counties in 2007 was even lower
than $871,000, what kind of taxpayers need an exemption for
$2 million of QPRI?
i) Limitation on QPRI for Mortgage Interest Deduction
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Purposes . Existing federal and state tax laws allow a
taxpayer to claim a deduction for mortgage interest but
limit the amount of the debt on which the accrued or paid
interest may be deducted to $1 million ($500,000 in the
case of a married individual filing separately). It is
unclear why this limit was raised to $2 million ($1 million
for married individuals filing separately) for purposes of
the COD income exclusion. Committee staff was unable to
find any explanation as to why this amount was increased
for purposes of the federal Act of 2007, as amended by P.L.
110-343.
j) Should there be a limit on the amount of COD income
eligible for the exclusion? The median home price in
California plunged 51% from $484,000 in March 2007 to
$247,590 in March 2009. Arguably, the 51% decrease in
value translates into approximately $238,000 of discharged
debt, and a potential amount of COD income, that would be
realized by the homeowner of a house who either has found a
buyer willing to pay less than the original loan amount in
a "short sale" (a sale where the lender agrees to accept a
loss in the principal amount to be repaid in order to
approve the sale) or convinced the lender to forgive part
of the principal amount of the loan on that house.
aa) High-income taxpayers benefit more than low-income
taxpayers . The proposed exclusion of COD income
disproportionately benefits taxpayers in higher tax
brackets because the "value" of an exclusion varies with
the marginal tax rate (or tax bracket) of the taxpayer.
Thus, when a taxpayer, who is in the 30% tax bracket,
excludes $100 of COD income, his/her tax is reduced by $30.
On the other hand, if the taxpayer is in a 20% bracket,
$100 of COD income excluded from his/her gross income would
reduce his/her tax liability only by $20. Because of the
progressive rate structure of our tax system, taxpayers in
higher tax brackets benefit more from income exclusions
than individuals in lower tax brackets. As
stated in the CRS report, this effect would be magnified if
homeownership is more concentrated among upper income
individuals. Thus, "the higher income taxpayer, with
presumably greater ability to pay taxes, receives a greater
tax benefit than the lower income taxpayer". (CRS report,
p. 8).
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bb) Existing tax incentives for homeowners . Existing law
already heavily subsidizes owner-occupied housing, even
without a COD income exclusion, by allowing a deduction for
mortgage interest and state and local real estate taxes,
and excluding up to 500,000/ $250,000 of gain on the sale
of a principal residence. In fact, according to the CRS
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.
cc) Extra benefit ? This bill, in conformity with the federal
tax law, allows the proposed COD income exclusion for QPRI
discharged by the lender. A taxpayer's home is considered
to be his/her principal residence if the taxpayer owned and
resided in that home for at least two of the previous five
years. It appears, therefore, that a taxpayer may claim an
exclusion of COD income "twice", to the extent that he/she
can establish that he/she has had two principal residences
in the last five years.
dd) Taxpayers' Behavior . Generally, tax expenditures are
enacted to provide certain relief, affect taxpayers'
behavior, influence business practices and decisions, or
achieve social goals. This bill benefits taxpayers
pursuing short sales, refinancing, mortgage modifications,
or mortgage forgiveness. However, given that 9.3% is
California's highest effective rate of personal income tax
(as compared to 35% under the federal income tax law), it
is unlikely that a change in the state income tax laws
would significantly impact taxpayers' decisions. Thus,
this bill provides tax relief to taxpayers who would not
have acted differently, regardless of this measure.
ee) Recommendations . Some analysts argue that millions of
dollars in mortgages were granted to marginal home buyers
at extremely low initial interest rates and that those
mortgages were aggressively marketed to unsophisticated
buyers. Is a buyer of a multimillion dollar house as
unsophisticated as a first home buyer of a more modest
house? Presumably, people who buy expensive homes have
some knowledge of lending procedures and practices, if not
professional help. Generally, the amount of household
income is correlated with foreclosure, in that those with
lower income are experiencing more financial hardship. If
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the policy rationale for the enactment of this bill is to
minimize hardship for households in distress, then the
Committee may wish to consider whether the proposed limits
of $2 million/$1 million for the QPRI income exclusion are
appropriate and whether those limits should be adjusted to
provide relief only to those households that are in need of
state assistance. The Committee may wish to consider
extending the same favorable treatment to COD income that
was available to homeowners in 2007 and 2008 tax years (SB
1055). Alternatively, the Committee may wish to limit the
application of this bill only to households with low and
moderate incomes or to allow an exclusion from gross income
only for a percentage of the taxpayer's COD income
(possibly, measured by a decrease in the highest median
price of a house in the county where the house is located)
in the year in which that income is realized and defer a
deduction of the remaining amount to future taxable years.
ff) Related Legislation .
SB 97 (Calderon), introduced in the 2009-10 Legislative
Session, extends the provisions of PIT Law to allow a
taxpayer to exclude from his/her gross income the COD
income generated from the discharge of QPRI in 2009, 2010,
2011, or 2012 tax year.
SB 1055 (Machado), Chapter 282, Statutes of 2008, amended the
PIT Law to conform to the federal Act of 2007, except that
it imposed certain limitations on the amount of QPRI and
COD income eligible for the exclusion. SB 1055 specified
that the exclusion applied to a discharge of QPRI that
occurred in the 2007 and 2008 taxable years.
AB 1918 (Niello), introduced in the 2007-08 Legislative
Session, was similar to SB 1055. AB 1918 modified federal
law to allow the exclusion for up to $1 million/$500,000 of
QPRI and did not impose any limitations on the amount of
COD income. AB 1918 was held in this committee.
REGISTERED SUPPORT / OPPOSITION :
Support
Howard Jarvis Taxpayers Association
California Taxpayers' Association
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California Mortgage Bankers Association
California Chamber of Commerce
California Credit Union League
California Association of Realtors
California Bankers Association
California Mortgage Association
Center for Responsible Lending
Irvine Chamber
Opposition
None on file
Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098