BILL ANALYSIS                                                                                                                                                                                                    






                                                                    AB 2234


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          Date of Hearing:  April 18, 2016


                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION


                           Sebastian Ridley-Thomas, Chair





          AB 2234  
          (Steinorth) - As Introduced February 18, 2016


                                      SUSPENSE


          Majority vote.  Fiscal committee.


          SUBJECT:  Personal income taxes:  gross income exclusion:   
          qualified principal residence indebtedness


          SUMMARY:  Extends indefinitely, in modified conformity to  
          federal law, the tax relief for income generated from the  
          discharge of qualified principal residence indebtedness (QPRI).   
          Specifically, this bill: 


          1)Provides that the Internal Revenue Code (IRC) Section 108,  
            relating to income from discharge of QPRI, as amended by The  
            Protecting Americans from Tax Hikes Act of 2015 (Division Q of  
            Public Law 114-113), shall apply, except as otherwise  
            provided.













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          2)Applies discharges to QPRI occurring on or after January 1,  
            2014.


          3)Provides that, notwithstanding any other law, no penalties or  
            interest shall be due to the discharge of QPRI for the 2014 or  
            2015 taxable year, regardless of whether or not a taxpayer  
            reports the discharge during the 2014 or 2015 taxable year.


          4)Makes findings and declarations stating that the retroactive  
            application of this bill is necessary for the public purpose  
            of preventing undue hardship to taxpayers whose QPRI was  
            discharged on and after January 1, 2014, and before January 1,  
            2016, and does not constitute a gift of public funds.


          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,


             d)   Debt discharged resulting from a non-recourse loan in  
               foreclosure.  A non-recourse loan is a loan for which the  











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               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, 2017.


          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 COD.













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          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 part 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.  The  
            amount of gain eligible for the exclusion is $250,000  
            (taxpayers filing a single return) or $500,000 (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)   Applies to the discharge of indebtedness occurring on or  
               after January 1, 2007 and before January 1, 2014.











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             b)   The maximum amount of QPRI is limited to $800,000  
               ($400,000 for a married/RDP individual filing a separate  
               return).


             c)   For discharges occurring in 2007 or 2008, the total  
               amount of non-taxable COD income is limited to $250,000  
               ($125,000 for 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 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, and 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 for  
            discharge of QPRI regardless of whether the discharge is  
            reported on the income tax return.


          FISCAL EFFECT:  The Franchise Tax Board (FTB) estimates an  
          annual revenue loss of $95 million in fiscal year (FY)  
          2015-2016, $50 million in FY 2016-2017, and $46 million in FY  
          2017-2018.


          COMMENTS:  













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           1)Author's Statement  :  The author provided the following  
            statement in support of this bill:


               AB 2234 removes an unnecessary impediment to financial  
               independence for troubled homeowners.  Those who have lost  
               their homes or are struggling to pay their mortgages should  
               not be subject to additional taxes.  California's recovery  
               from the recession remains sluggish and homeowners are  
               still getting back on their feet.  We can help that  
               recovery by allowing them to keep more of their hard-earned  
               income during such a critical time.  This legislation  
               provides relief to these families in the hope they are able  
               to stabilize their financial situation.  In addition, it  
               will end the ongoing uncertainty caused by the piecemeal  
               renewal of the income exclusion.


           2)Arguments in Support  :  Proponents of this bill state that the  
            Federal Government extended the tax treatment of forgiven  
            mortgage debt for the 2015 and 2016 tax years, so "by  
            conforming to federal law, both restoratively for the 2014 and  
            the 2015 tax years, AB 2234 eliminates a significant  
            impediment for homeowners seeking viable alternatives to  
            foreclosure during these tough economic times."  


          3)Mortgage Debt Forgiveness  :  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 $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,  











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            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.  On December 18, 2015, the Federal Government enacted  
            the Protecting Americans from Tax Hikes Act of 2015 and again  
            extended, for two additional years, the exclusion from gross  
            income for COD generated from the discharge of QPRI.   


          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  
            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  
            obtained 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.  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  


          ---------------------------


          <1> Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431  
          (1955).








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            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.  Existing law, however, provides several exceptions to  
            the general rule, for example allowing a taxpayer to exclude  
            COD income from his/her gross income if the debt is discharged  
            in Title 11 bankruptcy, if he/she is insolvent immediately  
            before the debt is cancelled, or if it is non-recourse debt.  


          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  
            non-recourse 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 as the entire amount  
            of the nonrecourse debt is treated as an amount realized on  
            the disposition of the property.  


             However, when a lender agrees to decrease the amount of the  
            original debt to reflect the current value of the property  
            secured by the debt, the cancellation of non-recourse debt  
            without a transfer of the property, such as in foreclosure,  
            creates COD income for the taxpayer.  Consequently, this bill  
            would continue to provide relief to a solvent California  
            homeowner who refinanced the first mortgage or obtained a home  
            equity loan or a home equity line of credit.  This bill will  
            also continue to 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.   











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          6)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 the 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  











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            increased.  As of February 2016, California's unemployment  
            rate stood at 5.5%, almost seven percentage points lower than  
            its post-recession peak of 12.0%.  (Employment Development  
            Department, Historical Civilian Labor Force, California, March  
            2016.)  Additionally, the number of seriously "underwater"  
            homes went from a peak of 12.8 million in 2012 to just 6.9  
            million in the third quarter of 2015.  The substantial  
            reduction in underwater homes has primarily been triggered by  
            a 35% increase in the national median home value since  
            bottoming out in 2012, and a recent dramatic pick up in home  
            sales volume and average sales price.  (RealtyTrac, Number of  
            Seriously Underwater Properties Drops 525,000 in Q3 2015 From  
            Previous Quarter, Down 1.2 Million From Year Ago, October 21,  
            2015.)  In light of substantial improvements to the economy,  
            the Committee may wish to consider whether an indefinite  
            extension of the exclusion for COD generated from the  
            discharge of QPRI is warranted.  


           7)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 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.   


          8)Importance of Federal Conformity :  This bill not only conforms  
            the exclusion from gross income for COD generated from the  
            discharge of QPRI to federal law for discharges occurring  











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            before January 1, 2017, but indefinitely excludes COD  
            indefinitely in future years, even if no federal exclusion is  
            provided.  Conformity with federal law reduces taxpayer errors  
            and eases tax filing and administration.  Although the federal  
            exclusion has been extended to include every year since 2007,  
            there is no guarantee that it will be continued past 2017.   
            The Committee may wish to consider whether state mortgage  
            forgiveness debt relief should apply in years when a similar  
            federal exclusion is not provided.  


          9)Technical Amendments  :  On Page 2, Line 8, strikeout "2015" and  
            insert "2017".  


             Additionally, the FTB has proposed the following technical  
            amendments: 


             On Page 2, Line 21, strikeout "2007 or 2009" and insert "2007,  
            2009, or 2013";


            On Page 2, Line 23, strikeout "2007 or 2009" and insert "2007,  
            2009, or 2013";


            On Page 2, strikeout Lines 24 through 34, inclusive;


            On Page 2, Line 35, strikeout "(f)" and insert "(d)";


            On Page 2, Line 35, strikeout "adding" and insert "amending".


           10)Related Legislation  :  SB 907 (Galgiani) would extend the  
            state exclusion of mortgage forgiveness debt relief to  
            discharges occurring in 2014, 2015, and 2016, and would  











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            provide that no penalties or interest would be imposed on  
            discharges occurring in 2014 or 2015.  SB 907 is pending  
            hearing by the Senate Committee on Appropriations.  


          11)Prior Legislation  : AB 99 (Perea), of the 2015-2016  
            Legislative Session, would have extended California's modified  
            conformity to the Mortgage Forgiveness Debt Relief Act for  
            discharges of QPRI until January 1, 2015.  AB 99 was vetoed.  


             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.  


             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.


            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.


            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.


            SB 401 (Wolk), Chapter 14, Statutes of 2010, amended the PIT  
            Law to conform to the federal extension of mortgage  











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            forgiveness debt relief provided in the Emergency Economic  
            Stability Act, with the following modifications:  (a) it  
            applies to discharges occurring in 2009, 2010, 2011, and 2012  
            tax years; (b) 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; (c) 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, (d) interest and penalties are not  
            imposed with respect to discharges that occurred in the 2009  
            taxable year.


          REGISTERED SUPPORT / OPPOSITION:




          Support


          California Association of Realtors
                                                                            

          California Bankers Association


          California Credit Union League


          California Mortgage Bankers Association


          California Taxpayers Association




          Opposition











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          None on file




          Analysis Prepared by:Irene Ho / REV. & TAX. / (916) 319-2098