Legal Opinion: CIS-0087

Index: 4.135, 4.225

Subject: 24 CFR 203.42 as Applied to Non-Profit Organizations

and Section 203(k) Escrow Commitment Procedures

April 9, 1996

MEMORANDUM FOR: John J. Coonts, Director, Office of

Insured Single Family Housing, HSI

FROM: John J. Daly, Associate General Counsel, Office of

Insured Housing, CI

SUBJECT: 24 CFR 203.42 as Applied to Non-Profit Organizations

and Section 203(k) Escrow Commitment Procedure

Your memorandum dated March 22, 1996 requested advice

regarding the impact of the word \"rental\" in 24 CFR 203.42 when

the mortgagor falls into the category of \"eligible non-occupant

mortgagor\" as defined in 24 CFR 203.18(f)(3).

The \"rule of seven\" or \"seven-unit limitation\" is stated in

24 CFR 203.42(a) as follows:

A mortgage on property upon which there is a dwelling to be

rented by the mortgagor shall not be eligible for insurance

if the property is a part of, or adjacent or contiguous to,

a project, subdivision or group of similar rental properties

in which the mortgagor has a financial interest in eight or

more dwelling units. \[Emphasis added.\]

Frequently section 203(k) mortgages are excluded from the

rule of seven by 24 CFR 203.42(b), which excludes such mortgages

when they are to be used for rehabilitation of property in an

area targeted for redevelopment by a State or local government

that has submitted a plan to HUD that describes the redevelopment

program. This memorandum does not address mortgages that fall

within the exclusion.

The rule of seven is designed to prevent insurance of a

mortgage under FHA single family programs if a mortgaged property

is related, financially and by location, to seven or more other

similar rental units that, collectively, could reasonably be

viewed as a multifamily project. The rule does not affect owner-

occupied one-family residences. It can limit the eligibility of

owner-occupied buildings with two-to four-family residences and

properties of any size that are not owner-occupied.

Section 203(g) of the National Housing Act (\"NHA\") provides,

subject to certain exceptions, that the Secretary may insure a

mortgage for a building for one-to-four families only if the

mortgagor is to occupy the building as his or her principal

residence or as a secondary residence, as determined by the

Secretary. Section 203(g)(2) lists six situations where the

property can qualify for mortgage insurance even if it is not

occupied by the mortgagor. These situations are described as

involving \"eligible non-occupant mortgagors\" in the implementing

regulations, 24 CFR 203.18(f)(3). Your inquiry involves two of

these situations.

The first \"eligible non-occupant mortgagor\" circumstance

that we will discuss in this memorandum is a non-profit

organization that can qualify as a mortgagor under

section 203(g)(2)(B) of the NHA because it is exempt from

Federal income taxation and intends to sell or lease the

mortgaged property to low or moderate-income persons, as

determined by the Secretary. Your memorandum states your

view that section 203(g) clearly does not consider these

non-profits to be owner-occupants. We agree; otherwise,

there would be no need to deal with non-profits in the

section 203(g)(2) list of exceptions. You further indicate

that the fact that non-profits may obtain the same level of

financing as owner-occupants does not absolve the non-profits

from the limitations of section 203.42; i.e., non-profits need

not be treated the same as owner-occupant mortgagors for purposes

of all requirements. We will discuss this issue in detail below.

The second \"eligible non-occupant mortgagor\" circumstance that we

will discuss is an investor mortgagor who will purchase and

rehabilitate a property with a rehabilitation loan insured under

section 203(k) of the NHA.

Eligible non-profit organization (non-section 203(k))

HUD has informed mortgagees that local HUD Offices must

determine the eligibility of non-profit organizations that will

serve as mortgagors; see HUD Handbook 4155.1, REV. 4 CHG. 1.,

paragraphs. 1-5A and 2-17. Once approved, however, a non-profit

will qualify as a mortgagor for a particular mortgage only if\--in

addition to being determined creditworthy by the mortgagee\--the

non-profit \"intends\" to sell or lease the mortgaged property to

be eligible for an insured mortgage. In order for the mortgagee

to determine that this test is met, and to make the appropriate

certification to HUD that the mortgagor is eligible, the

mortgagee should obtain some creditable evidence of the

mortgagor\'s intentions. HUD has not provided any written

instructions to mortgagees on this point.

The concept of \"rental\" property occurs twice in

section 203.42. That rule only applies if the property to be

mortgaged may fairly be considered a property \"to be rented by

the mortgagor\" within the meaning of section 203.42. If this

test is met, then section 203.42 restricts the number of nearby

\"similar rental properties\" in which the mortgagor may have a

financial interest. Regarding the \"to be rented\" test, we

conclude that this language is susceptible to more than one

interpretation and that Housing has the option to choose the

interpretation that best serves the objectives of section 203.42.

There are two main approaches to applying the rule.

The first approach would treat mortgaged property as

property to be rented only in the presence of some positive

indicator that rental will occur. For example, you could decide

to adopt a policy that applied section 203.42 only to property

that is actually rented at the time the property is acquired by

the mortgagor, with the possible exclusion of property for which

there is reason to believe that the rental status will end within

a limited period specified by HUD (such as to allow for eviction

proceedings). A related approach would also consider a vacant

dwelling as one \"to be rented\" whenever the mortgagor states a

clear intention to rent the property once acquired.

The other general approach that we find permissible under

section 203.42 would treat all property owned by a non-profit as

property to be rented in the absence of convincing evidence that

the property will not be rented. A property that might be rented

would be included. HUD could permit a mortgagee to rely on a

statement by the mortgagor that it intends to sell the property

to an eligible purchaser without any intervening rental period.

We believe HUD could also regard all property purchased by a non-

profit mortgagor with an FHA-insured mortgage as property to be

rented regardless of the non-profit mortgagor\'s statement of

intentions, in the absence of convincing evidence that the

mortgagor is legally obligated to resell the property.

In our view, the latter approach could be justified

as a reasonable implementation of section 203.42 because

the law does not require that a non-profit mortgagor

intend to sell the property in order to qualify for

mortgage insurance. HUD does not require a mortgagee

to obtain evidence of any binding commitment that a

non-profit mortgagor will sell rather than rent. Thus,

every non-profit mortgagor could potentially rent rather

than sell, or rent for a period before selling, without

violating any HUD program requirements. A non-profit

mortgagor might also purchase with a good faith intention

of reselling but later determine to retain the property

for rental. Because HUD and the mortgagee will have no

reliable means of distinguishing in advance the properties

which actually will be rented from those that will not,

HUD could justify treating all cases with non-profit

mortgagees as ones where the property is to be rented

(absent legal obligation to sell) in order to fully achieve

the objectives of section 203.42.

After Housing determines the criteria that will used to

identify properties to be rented, thus causing section 203.42

to apply, the next question would be which other units in

proximity to the property being purchased should be counted

toward the seven-unit limitation. Section 203.42 would

restrict the non-profit mortgagor to a financial interest in

no more than seven \"similar rental properties.\" A consistent

approach would be to count toward the seven-unit limitation

other units which the non-profit mortgagor holds under

circumstances similar to those that caused the property to

be acquired to be viewed as property to be rented. Thus,

if current actual rental is necessary to trigger the rule of

seven, other units should be counted toward the seven-unit

limitation only if actually rented or on the rental market.

If all units purchased by a non-profit without legal

obligation to resell trigger the rule of seven, regardless of

the purchaser\'s future intentions regarding the property, any

other units of the purchaser count against the seven-unit

limitation.

When Housing determines which of the possible applications

of section 203.42(a) represent the desired Housing policy,

paragraph 3-10 of HUD Handbook 4155.1 REV-4 CHG 1 should be

revised if necessary to reflect the policy accurately.

Currently, that paragraph appears to treat all mortgagors

other than owner-occupant mortgagors\--including non-profit

mortgagors\--as triggering section 203.42 in all situations.

Section 203(k) escrow commitment cases (including non-profits)

Any public, private for-profit, or non-profit mortgagor may

qualify for a section 203(k) mortgage even though it will not be

an occupant of the property. HUD has adopted a regulatory

policy that limits the mortgage amount for these mortgagors to

85 percent of the sum of the as-is property value and the

estimated cost of rehabilitation unless the mortgagee follows the

procedure known as \"escrow commitment\" as authorized by

24 CFR section 203.50(k). Under the escrow commitment procedure,

the investor mortgage may be for an amount not exceeding the

maximum mortgage amount available to an owner-occupant mortgagor,

but the excess over the 85 percent mortgage limit ordinarily

applicable to section 203(k) investor mortgagors must be

escrowed. Section 203.50(k) requires the investor mortgagor to

certify to the following:

\(1\) Before a due date approved by HUD (currently 18 months

after the mortgage is executed, according to paragraph 1-10 of

HUD Handbook 4240.4 REV-2), the mortgagor will not rent (except

for a 30-60 day term), sell (unless the mortgage is paid in full)

or occupy the property, unless HUD approves;

\(2\) If the property is not sold to an eligible owner-

occupant before the due date (e.g., the end of the 18 months),

all escrowed amounts will be applied on the due date to reduce

the outstanding mortgage balance; and

\(3\) Any escrowed funds not applied to the mortgage balance

shall be deducted from insurance benefits if an insurance claim

is filed.

Short-term rentals are expressly permitted by this

certification. In addition, we do not think that the mortgagor

is legally precluded from deciding to enter into longer term

rentals before the 18-month period has expired if it requests the

holder of the escrowed funds to apply the funds to the mortgage

balance. The mortgagee\'s certification that funds will not be

held in escrow longer than 18 months is not the equivalent of a

certification that funds will always be held in escrow for the

full 18 months, in lieu of application to the mortgage balance,

if no sale has occurred. The mortgagor may also rent the

property if the escrowed funds are applied to the mortgage

balance at the end of the 18 months.

The options for applying the rule of seven for escrow

commitment cases are similar to those discussed above for

non-section 203(k) non-profit mortgagors. It is permissible for

Housing to adopt approaches ranging from a focus on actual

rentals to an approach that treats all section 203(k) properties

without owner-occupant mortgagors as properties to be rented

within the meaning of section 203.42.

To the extent needed to reflect your desired policy, we

suggest revision of the first sentence of paragraph 4-6, HUD

Handbook 4240.2 REV-2, which currently states: \"A Borrower that

purchases property for rental purposes rather than rehabilitation

and sale, will be subject to the 7-unit limitation in

24 CFR 203.42.\" The ambiguous phrase \"for rental purposes\" could

be clarified. The \"Escrow Commitment Certification\" that is

Attachment 7 to Mortgagee Letter 95-40 requires each mortgagor

using the escrow commitment procedure to certify: \"I understand

the seven (7) unit limitation rule will apply.\" If Housing will

permit some exceptions instead of treating all escrow commitment

cases as triggering section 203.42, this certification should be

revised.

We would appreciate being informed of the Office of Housing

policy decisions make regarding application of section 203.42.