Understanding the Detached Structure Flood Insurance Exemption

Flood insurance rules have been a moving target in recent years.  Flood rules as we knew them changed overnight with the Biggert Waters Flood Insurance Reform Act of 2012.  Then, the rules changed again with the Homeowners Flood Insurance Affordability Act of 2014.  Furthermore, FEMA rescinded their longstanding guidance and the regulators have been slow to implement rules for both Biggert Waters and the Affordability Act.

Under the old rules, it was a known fact that a lender had to require a separate flood insurance policy for each structure located in a high-risk flood zone that secured a loan.  There were no exemptions.  This meant that if a farm secured a loan, each insurable “structure” on that farm would need to have a separate flood insurance policy.

The recent changes to flood insurance rules, however, have provided an exemption to this rule, as long as certain conditions are met.  

The Detached Structure Exemption for Flood Insurance

On July 21, 2015, interagency guidance was issued to provide clarification when the new exemption could be applied.  While each regulator has their own version of this rule, the following is section 330.4(c) of the FDIC’s rules on flood insurance:

339.4 Exemptions. The flood insurance requirement prescribed by 339.3 does not apply with respect to:

(c) Any structure that is a part of any residential property but is detached from the primary residential structure of such property and does not serve as a residence.  For purposes of this paragraph (c):

  1. “A structure that is a part of a residential property” is a structure used primarily for personal, family, or household purposes, and not used primarily for agricultural, commercial, industrial, or other business purposes;

  2. A structure is “detached” from the primary residential structure if it is not joined by any structural connection to that structure; and

  3. “Serve as a residence” shall be based upon the good faith determination of the FDIC-supervised institution that the structure is intended for use or actually used as a residence, which generally includes sleeping, bathroom, or kitchen facilities.

Four Part Test to Determine Exemption Status

As you can see from the interagency guidance, there are several things that must be considered when using the detached structure exemption. When I am trying to determine if a structure can be exempt from the flood rules, I break it down into a four part test:

  1. Test 1: Is it part of a residential property?

  2. Test 2: Is it used for personal, family, or household purposes?

  3. Test 3: Is it Detached?

  4. Test 4: Does it serve as a residence?

Let’s take a deeper look at each of these.

Test 1: Part of Residential Property

The first test to determine if a structure can be exempt from flood insurance is whether or not the structure is part of a “residential property.”  This means that if the structure is part of a commercial lot containing only commercial buildings, it would not be exempt.  Also, if a silo or barn is located on 100 acres of otherwise bare land, the exemption could not be used.  To qualify for the exemption, the structure must be part of “residential property.”  Therefore, a barn, silo, or other outbuilding would pass this first test if it is on the same plot of land as a dwelling.

Test 2: Used For Personal, Family, or Household Purposes

The second test embedded in this rule requires that a structure be used for personal, family, or household purposes and not for agricultural, commercial, industrial, or other business purposes.  This means that if I have a house with an outbuilding where I store my wife’s junk, this structure would be used for personal, family, or household purposes.  Or, if I have a barn where I keep horses I ride for fun on the weekend, then this would also be for personal, family, or household purposes.  On the other hand, if an Amish customer has a chicken barn where they raise chicken and sell them to a meat company (like Tyson), then the structure would be used for agricultural or commercial purposes.

The key with this test is to look at what is being done with the structure.  For example, if an outbuilding is used as a workshop for a hobby car collector, the exemption could apply.  On the other hand, if the same shop is used to fix up and sell cars, it would be considered used for commercial purposes and the exemption would not apply.  The bottom line is that we must look at the use of the structure and determine whether it is used for personal, family, or household purposes.

Test 3: Detached

The third test to determine whether or not a structure can be exempted from the flood insurance rules is if the structure if detached from the residence.  You would think that this is a simple test, and most times it would be.  However, I have seen many strange structures in my day where someone may build a covering, or even fully attach a deck, to what otherwise would be an outbuilding.  As long as the structure is in no way attached to the residence, then it will pass this test for a possible exemption.

Test 4: Serve as a Residence

The final test is whether or not a structure serves as a residence. The final rule says that this determination can be made by the lender, who would look for the presence of sleeping quarters, a bathroom, and a kitchen.  This “three room test” is the test utilized by the IRS to determine whether a property constitutes a “residence.”  For some structures, this test will be fairly straightforward, while others will be a bit more challenging.

The 2015 final rule expands upon how a financial institution would determine if a structure has a kitchen, bathroom, and sleeping quarters:

“However, given the numerous types of detached structures that could serve as a residence, the Agencies find that a single bright line test, for example, square footage or appraised value, to determine whether a structure serves as a residence, is not appropriate. Instead, the Agencies have concluded that a more practical approach to applying this exemption is to rely on the good faith determination of a lender on whether a detached structure serves as a residence. The Agencies believe the lender is in the best position to consider all the facts and circumstances involving a detached structure securing a loan, and this approach is similar to how the IRS evaluates whether property constitutes a “residence.”  In making this determination, as suggested by several commenters, the lender should focus on a structure's intended use. By focusing on the intended use of the structure, a lender could determine objectively whether a structure could serve as a residence and therefore not qualify for the exemption.”

The commentary continues on by stating the following:

“The Agencies note that the IRS definition of “residence” provides that a residence generally contains sleeping, bathroom, and kitchen facilities. The Agencies agree that a structure that serves as a residence would generally have such facilities. Therefore, a lender could examine the structure for the presence of these facilities to make a determination of whether it serves as a residence. However, the Agencies decline to accept certain commenters' suggestions that a structure must contain sleeping, bathroom, and kitchen facilities, and that the lack of at least one of these facilities would render the structure non-residential. Detached structures can vary greatly in terms of size, value, purpose, and facilities. Furthermore, not all three facilities are necessary in order for a structure to serve as an individual's residence. For example, a structure can have sleeping and kitchen facilities, while the resident makes use of a separate structure as a bathroom facility. Similarly, a structure can have sleeping and bathroom facilities but lack kitchen facilities. Because a structure without one or more of these facilities may be intended for use as a residence, the final rule provides that a structure could serve as a residence if it generally includes sleeping, bathroom, or kitchen facilities.”

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