S.1147

Mortgage Debt Forgiveness Tax Act of 1983

S.1147 would amend the Internal Revenue Code

retroactively to permit a taxpayer to exclude from his gross income (to the extent of the adjusted basis in his principal residence) discharge of indebtedness income realized with respect to certain "qualified mortgage indebtedness" and to reduce the basis in his principal residence by the amount of the discharge of indebtedness excluded from his income. Treasury cannot support this bill in its present form. agree, however, that the Code should be amended to permit individuals to defer the recognition of income realized on the prepayment of a home mortgage loan at a discount if adequate safeguards against abuse can be devised.

Background

We

Under Code section 61(a)(12), a taxpayer-debtor generally realizes gross income when he satisfies his loan obligation at less than its face amount in an arms-length transaction. The amount of income equals the difference between the face amount and the amount paid in satisfaction of the debt. Code section 108 establishes three specific circumstances where such discharge of indebtedness income may be excluded from a taxpayer's gross income: (1) where the discharge occurs in a title 11 bankruptcy case, (2) where the discharge occurs when the taxpayer is insolvent, or (3) where the indebtedness discharged is certain business indebtedness with respect to which a solvent taxpayer elects to reduce the basis of his depreciable property.

Recently, in order to reduce the number of low interest loans in their portfolios, financial institutions have been offering discounts to mortgagors who prepay the balance of their loans. Under current law, a financially solvent homeowner must recognize taxable income when, pursuant to such an offer from a financial institution (other than one from which the taxpayer purchased his principal residence), he prepays the mortgage on his principal residence at a discount.4/ For example, if the principal balance of the mortgage were $20,000 and the taxpayer paid $18,000 in full payment of the mortgage, the taxpayer must recognize $2,000 of ordinary income from the discharge of indebtedness in that year.

4/ Rev. Rul. 82-202, 1982-48 I.R.B. 5.

S. 1147

S.1147 would establish a new statutory exception to the rule that discharge of indebtedness income is included in income currently. Under this new statutory exception, a financially solvent homeowner who realizes discharge of indebtedness income with respect to the mortgage on his principal residence would be required to exclude that income from taxation and to reduce his basis in such residence. S. 1147 only applies with respect to certain "qualified mortgage indebtedness," which is defined as indebtedness incurred by an individual in acquiring his principal residence or in making improvements to his principal residence, the cost of which is taken into account in determining his basis in the residence.

The amendments made by S. 1147 would apply retroactively to taxable years beginning after December 31, 1953. A special rule would waive the statute of limitations in order to allow credit or refund claims arising by reason of the amendments to be filed within one year of the date of enactment.

Discussion

By requiring a private homeowner to reduce the basis in his home with respect to discharge of indebtedness income realized on the prepayment of his mortgage, S. 1147 would permit the taxpayer to defer the recognition of the income until he recognizes gain on the sale of the residence. However, in most cases, the deferred income would escape taxation entirely. For example, by reason of the nonrecognition rule of Code section 1034, to the extent that the taxpayer reinvests the proceeds from the sale of his principal residence in a new principal residence, the gain on the sale (including the deferred discharge of indebtedness income) would not then be recognized. If the taxpayer were to sell his principal residence after he attained age 55, he could elect under Code section 121 to exclude from income up to $125,000 worth of the gain (including the deferred discharge of indebtedness income). If the taxpayer owns the residence at death, his heirs would receive the property with a basis equal to its fair market value and the deferred discharge of indebtedness income would then go untaxed.

Under present law, there are many other ways that a taxpayer can "cash out" the economic benefit of a low interest mortgage without incurring a current tax liability. For example, if the taxpayer prepays at a discount a purchase

money mortgage provided by the seller of the property, Code section 108(e) (5) allows the taxpayer to reduce his purchase price (basis) for the property instead of recognizing discharge of indebtedness income. A homeowner also can obtain comparable economic benefits without current taxable income by refinancing the low interest mortgage with a second mortgage "wrapped around" the first mortgage. In this manner, the homeowner would be able to cash out the difference between the face amount and fair market value of the first mortgage in exchange for paying a higher interest rate on the second mortgage, without recognizing any taxable income currently.

Another way in which a taxpayer could realize the economic benefit of a low interest mortgage would be to sell his house subject to the existing mortgage (assuming there is no due on sale clause in the mortgage). Under such circumstances, the taxpayer would be able to increase the sales price for the house to reflect the fair market value of the favorable mortgage. As discussed previously, taxation of this amount of income may be deferred for a substantial period of time and may be exempt from tax. If this income is ever subject to tax, it would be taxed at capital gains rates.

In view of the above possibilities of obtaining comparable economic benefits with respect to a low interest mortgage in a variety of other ways, we recognize that there is some merit to the enactment of S. 1147.

Nevertheless, Treasury cannot support S. 1147 in its present form. The bill would apply retroactively to all taxable years beginning after December 31, 1953. Financial institutions have been offering discounts to mortgagors to prepay their low interest loans and some homeowners have accepted such offers with understanding that the income tax law requires discharge of indebtedness income to be recognized. We do not believe that such taxpayers should be accorded a windfall by the enactment of S. 1147.

In addition, we are concerned about the effect the enactment of S. 1147 would have in a compensation setting. For example, if an employer had loaned an employee money to purchase his principal residence, S. 1147, if enacted in its present form, may permit such employer to provide tax deferred (or as discussed previously, most likely tax exempt) compensation to the employee by forgiving all or a portion of the loan as a bonus.

For these reasons, Treasury cannot support S. 1147 in its present form. Nevertheless, we are willing to work with the Subcommittee in fashioning a narrower provision to provide appropriate relief to private homeowners who prepay their mortgage loans at a discount.

Senator DANFORTH. Now we have three different panels, one on S. 738, one on S. 1194 and S. 1195, and one on S. 1147. There are a total of 11 people testifying on these panels. Any written testimony will be included in the record in its entirety. But if we could keep the individual testimony to 5 minutes each, it would be greatly appreciated, and you can summarize your full statement for the record.

The first panel on S. 738, Messrs. Moore, Arnold, Considine, and McCrea.

Mr. Moore?

STATEMENT OF WILLIAM G. MOORE, JR., PRESIDENT AND CHIEF EXECUTIVE OFFICER, RECOGNITION EQUIPMENT, INC., DALLAS, TEX., ON BEHALF OF AMERICAN ELECTRONICS ASSOCIATION, WASHINGTON, D.C.

Mr. MOORE. Yes, sir. Senator, first of all, I come here not as an expert witness but rather as a company president. I am also on my maiden voyage in terms of ever testifying before a group like this, so I preface my remarks with that.

What I would like to do is I have submitted about 30 pages of testimony which has a lot of statistical data. I would like to use my 5 minutes to flavor that testimony if I can with some personal observations on the state of the high tech business and the effect of the legislation that you and Senator Bentsen are sponsoring. I propose to do that.

First of all, representing, as I do, the American Electronics Association, as well, I want to thank the administration and express our pleasure at the extension of the sunset provision, although we will gladly work with them for the total elimination of that provision and any other definitive things that have to be done under that legislation.

If I may, my background. I am currently president and chief executive officer of Recognition Equipment, which is located in an area now becoming Silicon Gulch out in the Dallas/Fort Worth area. Prior to joining Recognition Equipment, I was vice president for computer operations for the Perkin-Elmer Corp. out of Connecticut, and began my computer career about 15 years ago at Bell Laboratories, in New Jersey.

In supporting the legislation, S. 1194 and S. 1195, a couple of things come to mind that I want to reinforce. One is that we simply do not today have enough engineers and computer scientists to do the amount of R&D that we want to do. In that effect, S. 738 was a piece of lynchpin legislation that we desparately need. The problem, since there is some confusion, I think, deserves repeating. The problem is not that we do not have qualified graduates from high schools and colleges to go on to further education. The problem is we do not have enough space in the classroom to accommodate these people.

In addition to that, we do not have state of the art equipment in the colleges and universities to provide the necessary research and development and educational environment for these students, assuming we could fit them into the classroom and begin to accommodate those who want to be engineers or computer scientists. We

recognize that the high tech industry must play a role. Again it is our inclination to ask the administration and to ask the House and the Senate merely to provide an environment of fertility where, in fact, we can grow this business and do a number of things that would help in the area of computer literacy.

Computer literacy is probably the most significant buzz word in our industry today. It is the ability of someone to use and understand the basic computer concepts, everything from interfacing a terminal in a work environment to designing computer systems, both hardware and software. The only way that I know of to achieve computer literacy is to achieve it through hands on use of computers, computing equipment and the various software programs and packages that go with that.

In terms of the research and development orientation of our industry, my company routinely spends between 14 and 18 percent of its annual revenues on R&D, which is a fairly high number. Most of the companies in our industry spend at least 8 to 10 percent on an ongoing basis in this area.

We are facing ferocious international competition as well, where the cost of money is one of the biggest problems we face competitively. It is not only Japan, about which we have heard a lot, it is also France, Germany, United Kingdom, Singapore, et cetera. So any environmental conditioning that makes more money available to us in this international competition is a very positive factor.

A couple of other comments about what we see. Almost all of my contemporaries in the American Electronics Association and people with whom I deal see a definite sign of the pick up of the economic climate in the United States. There is also some minor sign that we may be seeing some pick up in Western Europe. We have seen also in our industry a very high level of initial public offerings of brand new computer companies, none of whom today take advantage of the various R&D provisions or are in a position today necessarily to donate equipment and services but will very quickly.

Finally, after having spent a week up here talking to Members of the House and the Senate, I am extremely encouraged very frankly at the level of sensitivity and awareness you have to the problem, and personally want to thank vou for your sponsoring legislation. Senator DANFORTH. Thank you, sir.

Mr. Arnold?

[The prepared written statement of Mr. Moore follows:]