BILL ANALYSIS
AB 1779
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Date of Hearing: April 12, 2010
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Anthony J. Portantino, Chair
AB 1779 (Niello) - As Introduced: February 9, 2010
Majority vote. Tax levy. Fiscal committee.
SUBJECT : Income tax: exclusion: income from discharge of
indebtedness.
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)Repeals the limitations currently imposed on a) the amount of
QPRI eligible for the exclusion, and, b) the total amount of
COD income that may be excluded from tax.
3)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.
4)Applies to discharges of indebtedness occurring on or after
January 1, 2007, and before January 1, 2013.
5)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:
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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 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
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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 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).
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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
on the return for the taxable year and the amount of estimated
tax paid.
3)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 $11 million
in fiscal year (FY) 2009-10, $14 million in FY 2010-11, $11
million in FY 2011-12, and $6.7 million in FY 2012-13.
COMMENTS :
1)Author's Statement . The author states that, "AB 1779 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)Arguments in support . The proponents of this bill state that,
from a California tax policy perspective, conformity with
federal tax laws provides 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 restores stability to the
market and kelps consumers "to move beyond the current
crisis."
3)Background . Two years ago, the Legislature approved SB 1055
(Machado), Chapter 282, Statutes of 2008, which provided
modified conformity to the Mortgage Forgiveness Debt Relief
Act (MFDRA) for discharge of mortgage indebtedness in the 2007
and 2008 tax years. Last year, the Legislature approved AB
1580 (Revenue and Taxation Committee) that contained a
provision that increased the maximum amount of COD income
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eligible for the exclusion and extended the tax relief until
January 1, 2013. In 2010, the Legislature approved SB x8 32
(Wolk) which was nearly identical to AB 1580. However, the
Governor vetoed both AB 1580 and SB x8 32, and, under existing
law, taxpayers must include cancelled mortgage debt as income
on their 2009 tax returns.
4)Why is COD income taxable ? While the idea of taxing COD
income is counter-intuitive to most people, the economic
theory behind existing law is sound tax policy 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.
5)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,
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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 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), Chapter 282, Statutes of 2008].
6)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.
7)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
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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 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.
8)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.
9)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
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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. 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.
10)Filing an amended tax return . This bill limits the tax
relief to COD income that is realized on or after January 1,
2007 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). This bill
would retroactively repeal those limitations imposed on the
maximum amount of QPRI and the total amount of COD income that
may be excluded. Consequently, any taxpayer who qualified for
the tax relief, under the Revenue and Taxation Code (R&TC)
Section 17144.5, in either 2007 or 2008 tax year, could file
an amended tax return to claim a refund based on the new
maximum amount of QPRI and COD income that may be excluded.
This Committee may wish to consider amending this bill to
specify that the repeal of the current California limitations
on the total amount of excluded COD income and the maximum
amount of QPRI would apply only to discharges of QPRI that
occur on or after January 1, 2009, and before January 1, 2013.
11)Limitation on QPRI for mortgage interest deduction 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/RDP individual
filing separately). It is unclear why this limit was raised
to $2 million ($1 million for married/RDP individuals filing
separately) for purposes of the COD income exclusion.
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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.
12)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.
13)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).
14)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
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nation's productivity and output.
15)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.
16)Related Legislation .
SB 401 (Wolk), introduced in the 2009-10 legislative session,
extends, among other things, mortgage forgiveness debt relief
through 2012, and provides that the total amount of COD income
excludable from gross income is increased to $500,000
($250,000 in the case of a married/RDP individual filing a
separate return). SB 401 specifies that interest and
penalties would not be imposed with respect to discharges that
occurred in the 2009 taxable year.
SB x8 32 (Wolk), introduced in the 2010 8th Extraordinary
Session, would have extended mortgage forgiveness debt relief
through 2012 and would have increased the maximum amount of
COD income that may be excludable from a taxpayer's gross
income to $500,000 ($250,000 in the case of a married/RDP
individual filing a separate return). SB x8 32 was passed by
the Legislature but was vetoed by the Governor.
SB x8 25 (Calderon), introduced in the 2010 8th Extraordinary
Session, would have extended mortgage forgiveness debt relief
through 2012, and would have provided that the total amount
excludable is limited to $500,000 ($250,000 in the case of a
married/RDP individual filing a separate return), and that
interest and penalties would not be imposed with respect to
discharges that occurred in the 2009 taxable year. SB x8 25
died in the Senate Revenue and Taxation Committee.
AB 111 (Niello), introduced in the 2009 legislative session,
was identical to this bill. AB 111 was held in this
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committee.
AB 1580 (Calderon), introduced in the 2009-10 legislative
session, would have extended mortgage forgiveness debt relief
through 2012, and would have provided that the total amount
excludable would have been limited to $500,000 ($250,000 in
the case of a married/RDP individual filing a separate
return). AB 1580 was vetoed by the Governor on October 11,
2009.
SB 97 (Calderon), introduced in the 2009-10 legislative
session, extended 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 97 was held by the Senate Revenue and
Taxation Committee.
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 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
California Association of Realtors
California Bankers Association
California Chamber of Commerce
California Credit Union League
California Manufacturers and Technology Association
California Taxpayers' Association
2 individuals
Opposition
None on file
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Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916)
319-2098