REALTORS® should proceed cautiously when working with organizations like Nehemiah or AmeriDream that provide seller-funded downpayment assistance because the Internal Revenue Service (IRS) has ruled that such programs do not qualify as tax-exempt charities.
The downpayment assistance programs at issue typically provide a gift of two to five percent of the purchase price to homebuyers who cannot afford the minimum downpayment or the closing costs required when getting a mortgage. The IRS said that it has increasingly discovered that groups claiming to be charities simply funnel downpayment assistance from sellers to buyers through self-serving, circular-financing arrangements. Usually there is a direct correlation between the amount of the downpayment assistance needed by the buyer and the payment received from the seller. In addition, the seller pays his or her generous donation only if the sale closes, and the organization usually charges a fee for its services. The IRS ruling indicates that the income received by groups operating in this manner is not exempt from federal income tax. Homebuyers receiving this assistance are treated as having received a rebate or price reduction and cannot include this amount in the home’s tax basis. Such programs can qualify as tax-exempt charitable and educational organizations under IRC § 501(c)3, but only when properly structured and operated.
A March 2005 report, “An Examination of Downpayment Gift Programs Administered By Non-Profit Organizations,” commissioned by the U.S. Department of Housing and Urban Development (HUD), found that seller-funded downpayment assistance has led to underwriting problems and an increase in the effective cost of homeownership, as did a similar government report in November 2005. Homes bought with seller-funded nonprofit assistance cost two to three percent more and are twice as likely to go into default. Many industry professionals were dismayed to have found that these “funnel charities” were counterproductive and at times actually increased instead of decreased the cost of a home for a first-time buyer.
For all FHA mortgages, the IRS ruling may disqualify this type of seller-originated downpayment assistance as an acceptable source of a gift. FHA rules specify that for all FHA mortgages, the donor of a gift used for the downpayment must be a relative, employer, labor union, charitable organization, government agency providing homeownership to lower income classes or a close friend.
The IRS said it is examining 185 organizations that operate downpayment assistance programs. A particular organization’s tax-exempt status can be verified using the online database at irs.gov by clicking on “Charities & Non-Profits” and then clicking on “Search for Charities.”
Revenue Ruling 2006-27 was published in Internal Revenue Bulletin 2006-21, dated May 22, 2006, online at
www.irs.gov/pub/irs-drop/rr-06-27.pdf.