BILL ANALYSIS
SENATE REVENUE & TAXATION COMMITTEE
Senator Lois Wolk, Chair
SB 97 - Calderon
As Introduced
Hearing: May 13, 2009 Tax Levy Fiscal: Yes
SUMMARY: Conforms California Law to Federal Mortgage Debt
Forgiveness Act through 2012.
EXISTING LAW EXISTING FEDERAL LAW provides that
cancellation of debt (COD) income, also known as discharge
of indebtedness, is generally included in gross income,
except 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. A loan is
non-recourse when the lender's only recourse
against the borrower is to repossess the asset.
EXISTING FEDERAL LAW, the Mortgage Forgiveness Debt
Relief Act of 2007 (P.L. 110-142), provides that taxpayers
may exclude qualified principal residence indebtedness
discharged after January 1, 2007 but before January 1,
2010. Married taxpayers may exclude up to $2 million in
qualified principal residence indebtedness, while married
persons filing separate or single persons may exclude up to
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$1 million. Taxpayers may only exclude COD income for
principal residences, which federal law limits to the
residence the taxpayer owns and uses as their principal
residence for two out of the last five years. The
Emergency Economic Stabilization Act of 2008, enacted
October 8, 2008, extended the exclusion of COD income for
federal income tax purposes for discharges before January
1, 2013.
EXISTING STATE LAW conforms to federal tax statutes
guiding cancellation of debt income, except that for
California purposes (SB 1055, Machado, 2008):
Taxpayers may only exclude COD income on
$400,000 single/$800,000 joint of qualified
principal residence indebtedness. Federal law
allows taxpayers to exclude COD income on $1
million/$2 million of qualified principal
residence indebtedness.
Taxpayers may only exclude COD income of
$250,000 single/ $500,000 joint
THIS BILL extends California's conformity to the
federal COD income exclusion at current limits for
indebtedness discharged until January 1, 2013.
THIS BILL also provides that penalties and interest do
no apply to discharges of qualified personal residence
indebtedness in 2009, regardless of whether the taxpayer
included the income.
FISCAL EFFECT:
The Franchise Tax Board (FTB) estimates revenue losses
resulting from SB 97 of $8 million in 2009-10, $8 million
in 2010-11, and $6 million in 2011-12.
COMMENTS:
A. Purpose of the Bill
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According to the author: SB 97 is a federal tax
conformity bill and is one part of a multi-part solution to
addressing California's mortgage problem. Right now if a
lender agrees to forgive some of a borrower's mortgage debt
that forgiven debt is taxed as ordinary income in the year
which the debit is forgiven. Three common situations in
which forgiven debt is taxable are 1) foreclosures on
refinanced mortgages 2) short sales and 3) deeds in lieu of
foreclosure.
SB 97 will provide immediate tax relief to
Californians upon its enactment. Once the bill is signed
into law, any qualifying California taxpayer will be able
to claim the bill's tax relief on his or her 2009 tax
return. Any taxpayer who files his or her 2009 tax return
before the bill becomes law and who wishes to take
advantage of the bill's tax relief will be able to file an
amended return upon the bill's signature. Those taxpayers
will not be subject to penalties or interest if they fail
to pay state income tax on forgiven debt when they file
their 2009 tax returns.
B. Conformity, Fairness, and Cribs
Last year, the Legislature enacted SB 1055, which
provided modified conformity to the MDFRA at lower limits
than federal law. While conforming state laws to their
federal counterparts eases difficulty for taxpayers and
preparers, conformity debates also turn on fiscal and
policy concerns. Unlike the Federal government, California
cannot neither print nor borrow money to subsidize its
budget, and initial estimates show that the U.S. Treasury
will have to borrow for approximately one-third of total
federal outlays in the next fiscal year. Therefore, the
Legislature must ostensibly make tradeoffs when considering
conformity to federal tax laws which do not cause
significant concerns in Congress.
This year, SB 97 reignites the debate between
advocates for full conformity and critics who argue that
the higher limits adopted in federal law reward high-income
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taxpayers. House prices have declined approximately fifty
percent statewide from the peak, more so in some areas, and
reports indicate that short sales (where the bank forgives
indebtedness, takes the capital loss, and the seller of
house receives COD income) are more frequent as a result,
so more Californians will be affected by California's
choice whether to enact COD income conformity (or lack
thereof). SB 97 seeks to extend California's existing
lower limits for COD income before January 1, 2013 instead
of opting for full conformity. Last year, when the
Committee approved SB 1055 (Machado), it cut the limits in
half from $1 million/$2 million to $500,000/$1 million, and
the Assembly subsequently halved the limits again to the
existing restrictions, and further provided that the
taxpayer had to subtract all COD income from larger loans
until reduced to $400,000/$800,000, at which point the
taxpayer may exclude COD income.
Modified conformity erases generally includible income
for most people receiving COD income while balancing other
public policy goals. First, income exclusions generally
benefit taxpayers in higher income brackets, so the higher
the limits, the more affluent the affected taxpayer.
Second, to have COD income above $800,000 (the maximum
amount of qualified principal residence indebtedness to
which COD income can be forgiven), indicates that the
affected taxpayer must have had sufficient income to
qualify for an $800,000 loan, and therefore are unlikely to
have great need of legislative forgiveness of COD income.
Should the state forgive the marginal amount of COD income
above existing limits for someone who has sufficient income
to purchase a home worthy of MTV Cribs? Also, taxpayers do
not receive COD income when the debt is non-recourse (the
loan is secured only by the asset funded by the loan), and
state law requires all indebtedness incurred to purchase a
home to be non-recourse. COD income only arises when the
debt becomes recourse, such as after a refinance, or taking
out a home equity loan.
However, the limits on the COD income exclusion
($125,000/$250,000) that the Legislature adopted last year
may not fully account for taxpayers with COD income who
live in areas with deleterious drops in property values.
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The Committee may wish to consider raising the existing
limits in recognition of escalating COD income resulting
from increased unemployment and greatly reduced property
values. Alternatively, instead of simply forgiving the
income above those limits but below the federal standards,
the Committee may wish to consider allowing the taxpayer to
defer the tax on the COD income for a specified period
above these amounts, thereby allowing the taxpayer a few
years after the equity-erasing short sale to pay the tax
due. Congress recently allowed taxpayers to defer income
arising from discharge of indebtedness resulting from a
reacquisition of business indebtedness over a five year
period as part of the American Recovery and Reinvestment
Act of 2009.
C. To Err is Human, To Forgive Legislative
According to several experts, the current mortgage
problem has many causes: lenders departing from historic
credit standards, underwriters and investors incorrectly
pricing risk, low interest rates, and mortgage products
predicated upon ever-rising home prices and infinite
refinancing opportunities. Many Californians now see the
fair market values of their homes falling well below the
amounts of their loan values with little sign of a bottom
ahead. Combined with declining values, many Californians
face escalating mortgage payments due to readjustments
contained in the current vintage of mortgages, which
promised low rates followed by much higher payments at the
end of the introductory period. Some homeowners have
sufficient income and home value to refinance, while others
who are unable to refinance may only be able to find buyers
willing to pay less than the original loan amount, dubbed a
"short-sale," where the lender must agree to accept a loss
in the principal amount to be repaid in order to approve
the sale. Others may be able to convince their lenders to
forgive part of the principal amount of the loan, although
lenders have primarily changed only interest rates, thereby
mitigating the readjustments, up to this point. Because
federal law has always considered cancelled debt includible
in gross income, Congress approved and the President signed
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the Mortgage Forgiveness Debt Relief Act of 2007, which
excludes cancelled debt income from income to help
homeowners facing this hardship, many of whom live in
California.
The economic theory supporting the recent federal tax
law change reflects the unique nature of the asset and the
problem. According to Tax Law Professor Debora A. Greier
of Cleveland State University, income tax law treats houses
as personal use assets providing personal consumption -
they are not depreciable, and losses are not deductible,
much different from stocks.<1> Greier states that current
income tax law assumes that any loss in a home's value is
due to personal consumption, such as not maintaining the
home and causing it to lose value; much like a car loses
value as a taxpayer consumes as he or she drives a car.<2>
However, Greier concludes that excluding cancelled debt
income in this case makes sense because larger market
forces cause the loss and affect all homes, and tax law
should consider the loss in the same way as non
personal-use items.<3> Greier adds that the sunset clause
in the federal changes is consistent with the temporary
nature of this market correction.<4>
D. The Phantom of the Opera
Including cancelled debt in gross income may be
intuitive to tax specialists, but has recently been
referred to as "phantom income." Considering cancelled
debt income is a long-standing tenet of federal tax law and
sound public policy. Taxpayers do not include borrowed
funds in income in the year received because of the
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<1> Statement of Deborah. A Greier before the United States
Senate Committee on Finance, P. 7
<2> Ibid, P. 8
<3> Ibid.
<4> Ibid.
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obligation to repay the loan - his or her financial status
is unchanged because the loan must be repaid. When lenders
reduce the principal amount on a loan, the taxpayer
realizes a gain in his or her financial situation because
some loan proceeds not previously gained taxed need not be
repaid. In U.S .v. Kirby Lumber Co., 284 US 1 (1931) the
Court held that a company that had issued $12 million in
bonds and later repurchased some of them at $138,000 less
than their face amount made a clear gain of $138,000,
clarifying a previous holding that tied the tax status of
the cancelled debt to the net effect of the initial
investment (Bowers v. Kerbaugh Empire Co, 271 U.S. 170
(1926)). Congress codified that discharged indebtedness is
income in 1954 but left considerable discretion up to the
Court. Recent federal tax law changes that SB 97 conforms
to depart from this long-standing rule in tax law.
E. Will SB 1055 Change Behavior?
Policymakers generally intend tax expenditures to coax
taxpayers to enact in positive ways - either economically
or socially - so-called positive externalities. For
example, California provides research and development tax
credits to spur innovation that leads to increased
employment and economic activity as well as superior
consumer products. Some tax expenditures seek to provide
equity - sales tax exemptions for food and prescription
drugs intend to reduce the cost of needed goods and don't
seek to change any behavior.
While SB 97 benefits taxpayers pursuing short sales or
mortgage forgiveness, few will change behavior. First, the
original lender incurs the loss when forgiving debt; the
tax obligation of the borrower will not likely factor in to
that decision. Second, the taxpayer's first concern is
escaping from a troubling or impossible mortgage, the
primary motivation for pursuing forgiveness of principal or
entering into a short sale. Third, before the recent
changes, federal tax law would deter a troubled homeowner
from pursuing a short sale or forgiveness, but given the
federal change, the marginal effect of the state tax
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exclusion will be small. A seller with a $500,000 loan
that agrees to a $400,000 short sale, thereby incurring
$100,000 in cancelled debt income would have added $29,000
to their income at the 29% rate before the recent federal
change. The seller must pay only $9,300 in income taxes at
the top California marginal rate - a rather small amount
compared to the relinquishment of a loan that exceeded fair
market value by $100,000 and the $29,000 in federal tax
forgiveness. While SB 1055 helps partially ease the
hardship taxpayers suffer because of rapidly declining home
prices combined with payment increases attributable to
mortgage products issued using faulty if not fantastic
assumptions and risk evaluations, the bill will likely
result in a benefit for taxpayers that would not have acted
differently regardless of this measure.
F. What About Second Mortgages and Home Equity Loans and
Lines of Credit?
The Mortgage Forgiveness Debt Relief Act uses existing
federal statutes that define eligibility to deduct
acquisition indebtedness, commonly known as the Mortgage
Interest Deduction, to qualify the income exclusion. This
definition provides that any debt both secured by the
residence and used to acquire, construct, or improve any
qualified residence of the taxpayer may be deducted.
Because SB 1055 conforms to this definition, taxpayers may
exclude cancelled debt income that meets that definition,
which would include second mortgages, home equity loans,
and home equity lines of credit used to improve the
residence. However, a taxpayer's exclusion of COD income
must be reduced by the amount of non-principal residence
indebtedness, the so-called "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
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residence indebtedness, meaning that $100,000 in COD income
is excluded for tax purposes, and $200,000 must be included
as income. Both federal and state law applies this rule.
G. Amendment Needed
SB 97 provides that penalties and interest do no apply
to discharges of qualified personal residence indebtedness
in 2009, regardless of whether the taxpayer included the
income. However, existing state law provides that
underpayments of quarterly estimated payments resulting
from bills enacted that affect the current taxable year are
not subject to penalties, so this provision is at best
duplicates current law, and should be deleted from the
measure.
Support and Opposition
Support:California Association of Realtors (If
Amended)
Oppose:None received
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Consultant: Colin Grinnell
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