Down-payment-assistance programs provide cash assistance to homebuyers who cannot afford to make the minimum down payment or pay the closing costs involved in obtaining a mortgage. Such programs can qualify as tax-exempt charitable and educational organizations under Internal Revenue Code section 501(c)(3) when properly structured and operated. In Revenue Ruling 2006-27, the IRS provides a detailed discussion of the guidelines – including two examples that meet – and one that fails to meet – the tests for exemption.

The ruling makes it clear that seller-funded programs are not charities because they do not meet the requirements of section 501(c)(3). Increasingly, the IRS has found that organizations claiming to be charities are being used to funnel down-payment assistance from sellers to buyers through self-serving, circular-financing arrangements. In a typical scheme, there is a direct correlation between the amount of the down-payment assistance provided to the buyer and the payment received from the seller. Moreover, the seller pays the organization only if the sale closes, and the organization usually charges an additional fee for its services.

Hud letter to lenders:

TO:  ALL APPROVED MORTGAGEES

SUBJECT: Charitable Organizations Making Downpayment Gifts

        Federal Housing Administration (FHA) approved mortgagees that seek FHA mortgage insurance on loans secured by single family houses, on which downpayment assistance has been provided to the borrower in the form of gifts, are required to determine that the gifts are from sources acceptable to FHA.  

      Paragraph 2-10 C of handbook HUD-4155.1 REV-5 provides that the donor of any such gift must be the borrower’s relative, the borrower’s employer or labor union, a charitable organization, a governmental agency or public entity that has a program to provide homeownership assistance to low- and moderate-income families or first-time homebuyers, or a close friend with a clearly defined and documented interest in the borrower.  For FHA, charitable organizations are those nonprofits that are exempt from income taxation under section 501(a) of the Internal Revenue Service Code (IRC) of 1986 pursuant to section 501(c)(3) of the IRC. 

      This Mortgagee Letter advises mortgagees about how to determine whether a gift from a charitable organization can be used for all, or part, of the borrower’s downpayment when the organization providing the gift for the downpayment loses or gives up its federal tax-exempt status.  Provided that the homebuyer has entered into a contract of sale (including any amendments to purchase price) on, or before, the date the IRS officially announces that the charitable organization’s tax-exempt status is terminated, FHA will recognize the gift—if made to the homebuyer and properly documented—as an acceptable source of the downpayment.  FHA believes this policy avoids harm to any homebuyer who, in good faith, has entered into a contract of sale in anticipation of receiving a gift for the downpayment from such a charitable organization.   

      The mortgagee [lender] is responsible for ensuring that an entity is a charitable organization as defined above.  One resource available to mortgagees for obtaining this information is the Internal Revenue Service (IRS) Publication 78, Cumulative List of Organizations described in Section 170(c) of the Internal Revenue Code of 1986, which contains a list of organizations eligible to receive tax-deductible charitable contributions.  The IRS has an online version of this list that can help mortgagees and others conduct a search of these organizations.  The online version can be found at: http://apps.irs.gov/app/pub78, using the following instructions to obtain the latest update.