Gift funds for a down payment to buy a home may come from relatives, employers, labor unions, the government, or a charitable organization. Traditionally, downpayment assistance programs (DAPs) are designed to help individuals with the purchase of a home by donating money to them from a general pool of gift money, grants, and contributions from businesses and the public. Here, it seems, charity starts with a home.
The donations are made to the buyer without the DAP having any relationship with the seller, the brokers, or any other party with a financial interest in the sale of the property. The disconnect between the DAP and anyone except the buyer is needed to prevent conflicts with the DAPs acting in the best interest of the buyer. On loans insured by the Federal Housing Administration (FHA), seller-financed down payments have long been prohibited in order to prevent conflicts of interest harmful to the buyer. (HUD Handbook 4155.1, REV-5, Paragraph 2-10c)
A relatively recent type of DAP actively purports to circumvent this prohibition by allowing parties with interest in the sale of property, specifically the seller, but orchestrated by the broker, to contribute to their buyer’s down payment.
Touted by alleged nonprofit charities, and more correctly called circular financing, the gift arrangement induces sellers to indirectly do what they cannot legally do directly. These circular-financing programs have come under government scrutiny for their adverse effects on buyers and the housing market due to their negative impact on foreclosure rates.
Who the DAP “Charities” Affect
The nonprofit DAPs are available to buyers under both conventional and FHA-insured loan arrangements. However, since FHA underwriting standards are less rigorous by design than conventional underwriting standards, the majority of these DAP scam victims are borrowers of FHA-insured loans. In other words, these DAPs are perpetrating fraud on the federal government.
The Environment of Home-Ownership Growth
The nonprofit DAPs took root during the 2001 recession, and then blossomed during the 2003 to 2005 housing boom for two reasons. First, real estate prices were rising, making the secondary mortgage market a lucrative vehicle used by securities dealers for investment by bond holders. Lenders seeking to broaden their market base implemented new loan programs for sale in the bond market, including option-ARM loan programs with low introductory interest rates, called teaser rates, that required low or no down payments and little or no income verification, called NINJA (No Income, No Job or Assets) loans. Second, these new subprime loan programs were supported by government policy aimed at making new homebuyers out of renters, individuals who would not otherwise qualify to buy a home, and add to the percentage of homeownership in America.
While the FHA market did not experience the same rapid expansion as conventional and subprime markets during this period, the same boom culture of fast growth nurtured the creation of the nonprofit DAPs. Like the pernicious new loan programs which opened homeownership to first-time buyers by offering low introductory rates, these DAPs appeared to be also benefiting the buyer. However, in the long run they have proven to be just as injurious as their subprime counterparts. Foreclosure rates experienced by the FHA insurance program demonstrate the nastiness of DAP assisted loans.
How Nonprofit DAPs Work
The buyer completes an application for downpayment assistance from the DAPs, encouraged nearly always by the broker handling the sale. Fueling the generosity, any assistance from the DAP is contingent on the seller participating by funding the entire gift program.
The seller, as a condition for use of the DAP’s funds, instructs escrow to “donate” from the seller’s funds a sum equal to the funds “gifted” to the buyer plus an administrative fee for the nonprofit’s efforts in the charitable transfer to the buyer. At the time of closing, the “gifted” funds are wired to escrow from the nonprofit’s general fund for the account of the buyer. In effect, the DAP launders money from the seller to the buyer, using its general fund as a go-between, keeping the un-gifted portion of the seller’s money as income to the DAP for facilitating the sale.
The nonprofits maintain they are charities. They claim they are merely donating funds to the buyer from their general fund, similar to the general funds held by the traditional downpayment assistance programs. According to the nonprofits, the buyers are the ultimate beneficiaries of this arrangement. In fact, they are not. On closer scrutiny, this arrangement benefits all parties to the transaction except the buyer who too often becomes a debtor imprisoned in his own home.
The traditional downpayment assistance programs make gifts without requiring or expecting repayment, in keeping with the HUD guidelines. In contrast, the nonprofit DAPs require the seller to contribute matching funds for their contribution to the buyer, in addition to the nonprofit’s administration fee for facilitating the buyer’s purchase. At no time is the nonprofit making the buyer a “gift”, but they do provide a service. The nonprofit, as a channel, provides the buyer with the downpayment funds to qualify for a loan, and at the same time, the seller moves his property and the broker gets paid. As the intermediary for this reverse exchange of funds, the nonprofit receives an administration fee. The nonprofit directly benefits from the seller’s contribution to their DAP program. All the while, this interaction is in direct conflict with the buyer’s best interests, unless the value of the home increases some 20% and remains above that level.
While this may appear to benefit buyers to overcome the hurdle of providing a down payment, consider the lender’s point of view. The buyers have no financial stake in the property they are buying, a serious moral risk for the lender and FHA to underwrite. Actuarial studies used by the HUD show that borrower equity in a property is the single most important indicator in loan performance, which comes as no surprise to anyone in the real estate industry. Since most FHA loans only require buyers to provide 3% of the purchase price as down payment, the beginning equity in the property is already low and the risk of default shouldered by the lender and FHA high. The circuitous DAPs allow buyers to acquire properties without even the initial down payment since the sales price is jacked up to fund the seller’s contribution through receipt of the proceeds from the new loan amount. When the market takes a negative turn or personal hardships arise, the buyers have little to no incentive to keep making payments in contrast to their having a down payment invested in the property. The data shows that among the gift-assisted loans, the circuitous DAPs’ gift-assisted loans had twice as high a default rate as other gift-assisted loans. Why the difference in default rates if both the traditional and nonprofit DAPs provide the entire down payment? (HUD Office of Inspector General Audit Report No.: 2000-SE-121-0001)
To make the contribution and fees needed to fund the buyers’ down payment, the seller typically raises the price asked for the property, and thus the amount of the FHA-insured loan, in order to recover his “donation”. Consider the FHA rules regarding seller gift funds: “Gifts from [sellers] are considered inducements to purchase and must be subtracted from the sales price.” However, the circuitous DAPs deceitfully allow sellers to circumvent the FHA rules for gifting funds to the buyer. Also, the circuitous funding of the buyer’s down payment enables the sellers to circumvent the mandated reduction in sales price for the amount the seller contributed (credited) to the buyer.
The seller indirectly donates money to the buyer, but raises the price of the property to compensate for the “donation” made to the nonprofit. This arrangement benefits the seller, the lender, the broker, and the nonprofit – they have all earned money from the transaction in an amount greater than the value of the property – but it leaves the buyer with a principal loan debt which is also greater than the value of the property in order to pay for the seller’s donation and facilitator fees. Immediately the buyer is at a serious economic disadvantage. He can neither refinance nor sell as he has no equity.
The situation only becomes worse for the buyer when the housing market cools and housing values drop within two or three years of the purchase. As a knock-off, this add-on effect of artificially increased prices spills over into the local housing market, as appraisers seldom, if ever, adjust for seller-inflated prices. Thus, any appraisal using the seller gift-assisted sales price of a comparable property will not reflect fair market value, all of which drives prices even higher, a virtuous cycle which inevitably turns vicious.
IRS & HUD Reactions
In March of 2000, rising concern over the harmful impact of the seller-contribution DAP programs prompted the HUD to perform an audit of the so-called “nonprofit” assistance programs. The HUD’s findings confirmed that the seller-contribution nonprofits were circumventing FHA requirements and the higher default rates their programs produced were increasing the risk of loss to the FHA’s insurance fund. In an attempt to shut the scam down and disallow sellers from indirectly providing the buyers’ down payment, the HUD issued Mortgagee Letter 00-28 in August of 2000 which proposed a rule mandating documentation of the source of gift funds, in an effort to deter improper seller contribution to qualify for an FHA insured loan. (HUD Office of Inspector General Audit Report No.: 2000-SE-121-0001; HUD Mortgagee Letter 00-28)
Overwhelming public response against the proposed rule, primarily from home builders and brokers, caused the HUD to withdraw the proposal in January of 2001 (under the new administration’s policy of homeownerhip expansion). In September of 2002, the HUD performed a follow-up report on the nonprofit DAPs and found that defaults under the nonprofit DAPs had risen more than four times what they had been in the original March 2000 audit. A general upward rate of default during the 2001 recession accounts for some of the increase; however, the nonprofit assisted loan default rates rose more than twice the default rate of loans without seller-contribution nonprofit assistance. The findings of the follow-up report recommended that nonprofit assistance programs allowing seller contributions should be disallowed as a violation of HUD rules. (HUD Directive FR-4469-N-02; HUD Office of Inspector General Audit Report No.: 2002-SE-0001)
From 2002 to 2005, no administrative action was taken by the HUD to curtail the activity of the seller-contribution nonprofits, despite the growing data suggesting the nonprofits were detrimental to buyers and the housing market at large. In part, this inaction can be attributed to HUD’s conflicting priorities. On the one hand, HUD recognized the default trends and its duty to protect home buyers from predatory housing practices and the government from financial losses.
On the other hand, HUD has a mandate from Congress to promote affordable housing and, at the time was under pressure from the administration of the federal government, including the president, to increase the numbers of homeowners and the national percentage of homeownership by facilitating the home buying process. The rising stock brokerage action in the mortgage-backed bond markets (CDOs) of 2003 to 2005 appeared willing and able to bear the influx of unqualified buyers, and HUD was reluctant to be seen as a barrier to the home buying process.
By 2006, the number of FHA insured loans with nonprofit assistance had increased to eight times the volume it was in 2000. With the rise in short-term interest rates commencing in August of 2005, and in an effort to put a damper on the excesses within the economic boom, the real estate market immediately began to show signs of slowing down. The cost of allowing unqualified buyers into the market now began to reveal itself with a vengeance. As property values began to drop in 2006, defaults began to rise rapidly.
The Internal Revenue Service (IRS) stepped into the breach in May of 2006. The IRS declared that any nonprofits allowing sellers to contribute to a buyer’s down payment were not true charitable organizations and did not qualify for federal tax exemption status. The IRS is now in the process of examining 180 nonprofit DAPs, and is revoking the charitable status for those that are found to facilitate the transfer of seller-contribution to the buyer’s down payment. One year on, HUD finally followed suit in May of 2007 and announced its plan to ban the seller-contribution-based nonprofit DAPs from participating in gift programs to buyers.
As the subprime market implodes under the weight of risky loans to unqualified buyers and prices drop on less expensive housing, a revival of interest in the use of FHA-insured financing may return. It remains to be seen whether the past management of prime-rate mortgage lending has the same pitfalls as their subprime counterparts. In any event, it appears the risk of homeownership undertaken by buyers is not always charitable. (IRS Revenue Ruling 2006-27)