AB 99
Page 1
Date of Hearing: March 23, 2015
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Philip Ting, Chair
AB 99 (Perea) – As Amended February 18, 2015
2/3 vote. Urgency. Fiscal committee.
SUBJECT: Personal income taxes: income exclusion: mortgage debt forgiveness
SUMMARY: Extends for one additional taxable year, in modified conformity to the recently
enacted federal law, the tax relief for income generated from the 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 Section 102 of the Tax Increase Prevention Act of 2014, shall apply,
except as otherwise provided.
2) Applies discharges to QPRI occurring on or after January 1, 2014, and before January 1,
2015.
3) Provides that, notwithstanding any other law, no penalties or interest shall apply be due to the
discharge of QPRI for the 2014 taxable year, regardless of whether or not a taxpayer reports
the discharge during the 2014 taxable year.
4) Makes findings and declarations stating that the retroactive application of this bill is
necessary for the public purpose of conforming to federal law, and thereby preventing undue
hardship to taxpayers whose QPRI was discharged on and after January 1, 2014, and before
January 1, 2015, and does not constitute a gift of public funds.
5) Provide that this is an urgency statute necessary for the immediate preservation of the public
peace, health, or safety.
EXISTING FEDERAL LAW:
1) Includes in the gross income of a taxpayer an 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,
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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 the case 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, 2015.
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 port 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
year or more. The 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:
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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 married/RDP filing
separate).
c) For discharges occurring in 2007 or 2008, the total amount of non-taxable COD income
is limited to $250,000 ($125,000 in the case of 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 cancellation of debt income exclusion is $500,000 ($250,000 for married/RDP
filing separate).
e) 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. However, no underpayment penalty or
interest is assessed for the 2007, 2009, and 2013 taxable year.
FISCAL EFFECT: The Franchise Tax Board (FTB) estimates an annual revenue loss of $42
million in fiscal year (FY) 2014-2015, and $5.2 million in FY 2015-16.
COMMENTS:
1) Author's Statement: The author provided the following statement in support of this bill:
AB 99 would extend the tax relief on forgiveness of mortgage debt by conforming
California law to federal law. 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.
2) Arguments in Support: Proponents of this bill state that "when debt is forgiven by a lender as
part of an agreement with a borrower using the short sale process or a principal reduction, the
borrower should not be penalized on their state income taxes. Many borrowers who faced
foreclosure last year and successfully negotiated a loan modification may well find
themselves once again unable to make their mortgage payment if they are saddled with a tax
burden resulting from forgiven debt."
3) Mortgage Debt Forgiveness: Background. SB 1055 (Machado), Chapter 282, Statues of
2008, provided modified conformity to the Mortgage Forgiveness Debt Relief Act (MFDRA)
for discharge of mortgage indebtedness in 2007 and 2008 tax years. SB 401 (Wolk), Chapter
14, Statues 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 taxpayer's gross income from
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$250,000 ($125,000 in case of married individual/RDP filing 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 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. On
December 19, 2014, the Federal Government enacted the Tax Increase Prevention Act 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.
4) Why is COD Taxable? Most individuals find the idea of taxing debt cancellation counter
intuitive, 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. According to Commissioner
v. Glenshaw, the Court defined income as an accession to wealth, that is clearly realized, and
over which the taxpayer has complete dominion1. 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. 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
taken out 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.
Additionally, 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.
5) 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 nonrecourse 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.
However, if a lender agrees to decrease the amount of the original debt to reflect the current
value of the property secured by the debt, the transaction will be considered COD and subject
to tax - the cancellation of non-recourse debt without a transfer of property creates COD
income for the taxpayer in an amount equal to the amount cancelled by the lender. California
law provides relief to a solvent homeowner who refinanced the first mortgage or took out a
home equity loan or a home equity line of credit. California law provides 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.
1
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
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6) Insolvency: COD is not included in income to the extent the taxpayer is insolvent
immediately before the debt is cancelled. A taxpayer is insolvent immediately before the
COD to the extent that the amount of total liabilities exceeds the FMV of all assets
immediately before the cancellation. This provision may be used in lieu of the QPRI
exclusion. It is important to remember, however, that the exclusion applies only to the extent
of insolvency. As an example, assume a taxpayer has discharged debt of $5,000. Before the
cancellation of debt, the taxpayer had $10,000 in liabilities and the FMV of all assets was
$7,000, meaning that before the cancellation, the taxpayer was insolvent to the extent of
$3,000 (total liabilities minus FMV assets). Therefore, the taxpayer may exclude $3,000
from income and include $2,000 as income of the discharged debt.
7) Why exclude COD from Gross Income? Despite the economics of taxing COD, the rationale
for excluding cancelled mortgage 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 from gross
income may help maintain consumer spending, which may help prevent a recession.
As noted earlier, one of 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
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 November
2014, California's unemployment rate stood at 7.2%, five percentage points lower than its
post-recession peak of 12.4%, but 2.4% higher than its pre-recession low of 4.8%. (Public
Policy Institute of California, The California Economy: Unemployment Update, December
2014.) Additionally, the number of seriously "underwater" homes went from a peak of 12.8
million in 2012 to just over 7 million in the fourth quarter of 2014. The reduction in
underwater homes has primarily been triggered by a 35% increase in the national median
home value since bottoming out in 2012. (RealtyTrac, Seriously Underwater Properties
Decrease by 2.2 Million in 2014, Down 5.8 Million From Peak Negative Equity in Q2 2012,
January 21, 2015.) In light of substantial improvements to the economy, the Committee may
wish to consider whether an extension of the exclusion for COD generated from the
discharge of QPRI is warranted.
8) 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
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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 personal consumption.
9) Prior Legislation:
a) AB 1393 (Perea), Chapter 152, Statute of 2014, extended California’s modified
conformity to the Mortgage Forgiveness Debt Relief Act for discharges of QPRI until
January 1, 2014.
b) AB 42 (Perea), of the 2013-14 Legislative Session, would have extended, for one
additional taxable year, in modified conformity to federal law, the tax relief generated
from the discharge of QPRI. AB 42 was held by the Assembly Appropriations
Committee.
c) SB 30 (Calderon), of the 2013-14 Legislative Session, would have extended for one
additional taxable year, in modified conformity to federal law, the tax relief generated
from the discharge of QPRI. SB 30 was held by the Assembly Appropriations
Committee.
d) AB 856 (Jeffries), of the 2011-12 Legislative Session, would have conformed fully to the
Mortgage Forgiveness Debt Relief Act as extended by the Emergency Economic
Stabilization Act to discharged debt occurring on or after January 1, 2010, and before
January 1, 2013. AB 856 was held by this Committee.
e) AB 111 (Niello), of the 2009-10 Legislative Session, would have provided the same
exclusion from gross income for mortgage forgiveness debt relief that is allowed under
federal law for discharges occurring on or after January 1, 2007, and before January 1,
2013. AB 111 was held by this Committee.
f) SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the PIT Law to conform to the
federal extension of mortgage forgiveness debt relief provided in the Emergency
Economic Stability Act, with the following modifications: (i) it applies to discharges
occurring in 2009, 2010, 2011, and 2012 tax years; (ii) the total amount of QPRI is
limited to $800,000 ($400,000 in the case of a married individual or domestic registered
partner filing a separate return; (iii) the total amount excludable is limited to $500,000
($250,000 in the case of a married individual or domestic registered partner filing a
separate return); and, (iv) interest and penalties are not imposed with respect to
discharges that occurred in the 2009 taxable year.
g) AB 1580 (Calderon), of the 2009-10 Legislative Session, was similar to SB 401 (Wolk).
AB 1580 was vetoed.
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h) SB 97 (Calderon), of the 2009-10 Legislative Session, would have 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 on the Senate Revenue and Taxation Committee's Suspense File.
i) 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.
j) AB 1918 (Niello), of 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 by this
Committee.
REGISTERED SUPPORT / OPPOSITION:
Support
Board of Equalization Member George Runner
California Association of Realtors
California Bankers Association
California Credit Union League
California Mortgage Bankers Association
California Society of Enrolled Agents
California Taxpayer Association
1 individual
Opposition
None on file
Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916) 319-2098