Keeping Up with the Rising Tide- Flood Insurance Changes are Coming- A Three Part Series

Part One:  The Detached Structure Exemption  

Over the past several years, the contours of the flood insurance rules have experienced significant changes.   Both the Biggert Waters Act and the Homeowners Flood Insurance Affordability Act (“HFIAA”) have introduced long sought changes to the way flood insurance will be administrated.   As always, with changes to regulations, there are many questions about how the changes will affect the financial institutions that make loans with collateral in a flood zone.  This series will explain the three most recent changes.    

Non Residential detached structures will NOT require flood insurance.  

This is a big change.  Since the inception of the flood insurance program, one of the rules that has vexed loan officers was the need to get insurance on that proverbial tool shed or pole barn in the yard that was worthless.  You know the routine, I am sure.  The examiner cites your bank for failure to get insurance because there is a structure in the back of the property.  “But the property is worthless”, you say; alas, the rule was “three walls and a ceiling make it insurable”.  Well, this is no longer the case!   The new rules exempt from coverage any nonresidential structures that are detached from the collateral property.   BEWARE: This exemption does not apply to commercial or agricultural structures.  There are several key points to remember when making the determination not to cover structures with flood insurance.  

Collateral: 

The first thing to remember is that exemption applies regardless of the purpose of the loan.  Whether or not the reason for the loan is commercial or for personal reasons the exemption will apply as long as the collateral being pledged is a residence.  So, if the borrowers are pledging their home to start their own business, the detached structure exemption will apply.   ^[1]  

Residential Property 

The next thing to consider is the definition of what is “residential property”.  There was quite a bit of discussion about what this means.  When the proposed rules were published there were advocates that wanted the definition to include “residential improved property” which would include all of the structures on a residential property.  The agencies made it clear that this definition is too broad because it might have the effect of exempting commercial or agriculture structures on a property.    For purposes of the flood insurance rule, the agencies decided to combine the definitions used by HUD and Regulation Z.    The HUD definition of a residence is:

Residential property means a dwelling unit, common areas, building exterior surfaces, and any surrounding land, including outbuildings, fences and play equipment affixed to the land, belonging to an owner and available for use by residents, but not including land used for agricultural, commercial, industrial or other non-residential purposes, and not including paint on the pavement of parking lots, garages, or roadways.” [2]

 

 

While Regulation Z’s definition “residential property” specifies that: 

“A structure that is part of a residential property” refers to a structure used primarily for personal, family, or household purposes, and not used primarily for agricultural, commercial, industrial, or other business purposes”[3]

When you put these two definitions together, the term residential property means that if a structure is used as a residence, it must have flood insurance.   A garage that has been converted into a living unit would fit this definition.  At the end of the day, the final call is left to the lender, but if there are people living in the structure at the time the loan is made, the structure is residential.  The rule also goes on to consider the case of multi-family dwelling units: these are considered residential properties for the purpose of the flood rules. [4] 

What if a building is both commercial and residential?  For the exemption to apply the structure has to be more than 50 percent residential.  Remember, when we are talking about the exemption, we are talking about the other structures on the property.  The residential structure itself must have flood insurance.   

Structures with value

Suppose you have determined that a detached structure is not residential and is exempt, but the structure has significant value?      

“The Agencies believe detached structures used for commercial, agricultural, or other business purposes should be protected adequately by flood insurance as collateral given their value to the borrower and lender, and should not be covered by the detached structures exemption^[5] “

Keep in mind then, that if there is something like a greenhouse on residential property, it is not a residential structure and is technically exempt.  However, safe and sound banking principles may require that this structure should be covered with flood insurance.  Be careful when using the exemption.    

Detached

The next issue to consider is whether the structure is detached.   There have been several versions of what detached meant in the past.  The new rules make it clear that detached is just what it sounds like.  The structure cannot be attached to the residence in any way.   There can be no breezeway or walkway or any other connection to the residence.  If so, the structure is part of the residence and needs insurance.  If the structure is detached and it does not serve as a residence, there is no need to get flood insurance [6]

Serve as Residence

The final area to consider for the exemption is whether or not a structure serves as a residence.  There was a great deal of confusion and comment about the definition of “serve as a residence”.  In the end, the rule uses the IRS definition:

“IRS regulations provide that “[w]hether property is a residence shall be determined based on all the facts and circumstances, including the good faith of the taxpayer. A residence generally includes a house, condominium, mobile home, boat, or house trailer that contains sleeping space and toilet and cooking facilities. A residence does not include personal property, such as furniture or a television that, in accordance with the applicable local law, is not a fixture.” [7]

 

Ultimately, it is up to the lender to make the determination about whether or not a structure serves as a residence.  There is no formula other than the “sniff” test.  If people are living in the structure it IS a residence for flood insurance purposes.  The good news here is that this is a onetime determination.  If at the time the loan is made, there is no one living in the structure and it did not appear to be a residence, it would not require flood insurance.  There is no duty to continue to check to see whether or not the status of the property has changed.  

In summary, there several steps to take when determining whether or not the nonresidential structure exemptions applies.  Remember, this exemptions does not apply for commercial and agricultural structures.  Steps for determining the flood insurance exemption

Step One: Real property is pledged as collateral

Step Two:  Determine if the property is in a flood zone

Step Three: Determine if the property being pledged is a residence or serves as a residence.  If No, the exemption does not apply.  If yes, continue to step Four

Step Four:  Assess whether or not there are additional structures on the property. 

Step Five:  Determine whether additional structures are detached

Step Six: Determine whether detached structures serve as a residence.  If No, then no flood insurance is required for these structures.  If yes, additional flood insurance is required.

Step Seven:  Calculate the proper amount of insurance

Best practice:  Determine whether detached structures have significant commercial or agricultural value- additional insurance may be required.  

 

Part two of this Series will cover forced-placed flood insurance rules 

 

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[1] The property could later serve as a residence, but if it does not at the time the loan is made, then the exemption applies

[2] 24 CFR 35.110.

[3] See 12 CFR 1026.1(c)(1).

[4] See Interagency Questions and Answers Regarding Flood insurance #51

[5] FIL-32-2015

[6] Although, see above structures with value

[7] See 26 CFR 1.163-10T(p)(3)(ii).