When the guidelines for the detached structure exemption from flood insurance were first announced, many jumped for joy. Over the years, many of customers and lenders alike have argued that flood insurance shouldn’t be required for certain detached structures, though flood insurance rules have traditionally required flood insurance for any collatoralized structure located in a high-risk flood zone, regardless of whether or not it was a residence, commercial building, or storage shed. So, when the Homeowners Flood Insurance Affordability Act of 2014 provided for an exemption for flood insurance for certain detached structures, many were excited to quickly use the detached structure exemption to avoid flood insurance.
Unfortunately, many soon realized that the detached structure exemption couldn’t be used for every detached structure that was not a residence. In addition, some ambiguity in the rules left many wondering which structures could actually qualify for the detached structure exemption. For example, one of the main questions we continue to see is this: Can detached structures on investment properties still qualify for the exemption from obtaining flood insurance?
A Background on the 2015 Interagency Guidance for the Detached Structure Exemption
To understand whether the detached structure exemption can be used for investment properties, let’s first review the actual guidance for using the exemption. On July 21, 2015, the regulatory agencies issued Interagency Guidance to explain how the detached structure exemption would work. This guidance explains that not all detached structures could be exempted from flood insurance requirements. Specifically, the detached structure exemption could only be used if four “tests” were passed:
The detached structure must be part of “residential property.”
The detached structure must be used for personal, family, or household purposes.
The structure must be detached from a residence.
The structure cannot also serve as a residence.
You can learn more about this four part test for the detached structure flood insurance exception here.
Determining Whether Investment Property is Considered Residential Property
Upon first thought, many have assumed that a detached structure on an investment property could not qualify for the exemption from flood insurance as the investment property would not be for personal, family, or household purposes. This, however, does not appear to be a correct assumption.
In fact, the prefatory text included with the 2015 Interagency Guidance appears to clarify that the detached structure exemption can apply to rental properties. When we look at the four step test outlined previously, we see that the first test is that a detached structure must be part of “residential property.” This test does not say that the residential property cannot be a rental property or that the loan securing the property must be for consumer purposes. The test is to determine whether the structure is part of “residential property.”
As we can see in the prefatory text to the 2015 Interagency Guidance, the regulators have intended the term “residential property” to be interpreted broadly, and to generally include renter-occupied investment properties, so long as the building is used primarily for residential purposes:
“Although the Agencies decline to adopt the FDPA's definition of “residential improved real estate” for “residential property,” the Agencies agree with commenters that “residential property” should be interpreted as broadly as “residential improved real estate” as set forth in the Interagency Questions and Answers Regarding Flood Insurance (Q&As). Commenters in particular referenced Q&A 51, which indicates that “residential improved real estate” does not distinguish whether a building is single- or multi-family, or owner- or renter-occupied, and includes single-family dwellings, two- to four-family dwellings, multi-family dwellings containing five or more residential units, and mixed-use buildings, so long as the building is used primarily for residential purposes.”
In addition to this explanation, the Interagency Guidance makes it clear that financial institutions should take reasonable steps to determine that a structure is, in fact, being used as a residence:
“Although the Agencies decline to accept “actual use” as an appropriate indicator of residency by itself, a lender should take reasonable steps to determine if a structure is actually occupied by a resident. Therefore, the Agencies clarify that whether a detached structure in a residential property serves as a residence shall be based upon the regulated lending institution's good faith determination that the structure is intended for use or actually used as a residence.”
Business Purpose Loans Still Exempt
In addition to explaining that a residential property can included renter-occupied properties, the Interagency Guidance clarifies that the purpose of the loan (consumer vs. business purpose) doesn’t really matter if the structure (i.e. dwelling) is going to be used for residential purposes. In other words, an investment property that is rented out for residential use is still considered residential even if the loan has a commercial, business, or agricultural purpose. In fact, the prefatory text to the Interagency Guidance makes this abundantly clear:
“The Agencies acknowledge that, with respect to flood insurance, the purpose of a loan may be immaterial to the borrower when the borrower uses his or her residence to secure the loan. Therefore, the Agencies agree with commenters that the detached structure exemption should be available in connection with consumer loans as well as those made for business, commercial, or agricultural purposes if the loan is secured by a residence.”
Business Purpose Detached Structures Not Exempt
It is important to clarify here that this business purpose discussion only applies to the purpose of a loan and the “residence” on the property. You see, detached structures that, by themselves, have a business, commercial or agricultural purpose are not exempt from flood insurance requirements and must carry flood insurance if the collateralized structure is located in a high-risk flood zone. This clarification is also made in the Interagency Guidance as follows:
“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.”
The bottom line here is to keep in mind that detached structures on business purpose loans may still be exempt, detached structures that have a business, commercial or agricultural purposes are not exempt and absolutely require flood insurance.
In other words, a detached structure can only qualify for the exemption if (after it is determined to be part of a residence) the detached structure is actually used for consumer, personal, or household purposes. On the other hand, if the structure is used for business, commercial, or agricultural purposes - such as a mechanic shop, landscape business, or even a commercial chicken farm - then the detached structure cannot qualify for the exemption.
Summarizing the Detached Structure Exemption for Investment Properties
To summarize the requirements to obtain flood insurance on detached structures that are part of an investment/rental property, we can look at two different tests:
Test 1: We must determine if the detached structure is part of “residential property.” This could be a consumer purpose dwelling or a business purpose rental. Either way, the detached structure must be part of property that includes a residence.
Test 2: We must determine the purpose of the detached structure. If the detached structure will be used for consumer, personal, or household purposes, the structure may be exempt from flood insurance requirements (assuming it meets all of the other qualifications for being exempt). If, however, the detached structure is used for business, commercial, or agricultural purposes, then the detached structure would not qualify for the exemption and would require flood insurance.
Now, all of this said, a financial institution still has the option to require flood insurance on any detached structure as a matter of safety and soundness. Therefore, some financial institutions may choose this conservative approach to appease regulators rather than jump through the complicated hoops of determining whether each detached structure qualifies for an exemption to food insurance.