ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Philip Ting, Chair. AB 99 (Perea) As Amended February 18, 2015 SUSPENSE

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1 Page 1 Date of Hearing: May 18, 2015 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Philip Ting, Chair 2/3 vote. Urgency. Fiscal committee. AB 99 (Perea) As Amended February 18, 2015 SUSPENSE 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, ) 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,

2 Page 2 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, ) 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 ) 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:

3 Page 3 a) Applies to the discharge of indebtedness occurring on or after January 1, 2007 and before January 1, 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) , and $5.2 million in FY 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

4 Page 4 $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, 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, ) 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 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. 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).

5 Page 5 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 The reduction in underwater homes has primarily been triggered by a 35% increase in the national median home value since bottoming out in (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

6 Page 6 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, b) AB 42 (Perea), of the 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 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 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, AB 856 was held by this Committee. e) AB 111 (Niello), of the 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, 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 Legislative Session, was similar to SB 401 (Wolk). AB 1580 was vetoed.

7 Page 7 h) SB 97 (Calderon), of the 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 Legislative Session, was similar to SB 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 Attorney General's Office Board of Equalization Member George Runner California Association of Realtors California Bankers Association California Credit Union League California Independent Bankers California Mortgage Bankers Association California Society of Enrolled Agents California Taxpayer Association One private individual Opposition None on file Analysis Prepared by: Carlos Anguiano / REV. & TAX. / (916)

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