A recent IRS ruling that restricts the use of downpayment assistance has mortgage bankers pushing for FHA reform.

The IRS issued Thursday the Revenue Ruling 2006-27, which will rescind the 501(c)(3) status of a large number of nonprofit organizations who receive funding from property sellers in providing downpayment assistance to FHA borrowers, the Mortgage Bankers Association announced.

"The ruling by the IRS significantly hampers FHA's ability to serve first-time, minority and low- and moderate-income homebuyers by eliminating a source of downpayment for over a third of FHA's borrowers," said MBA vice president of government affairs Steve O'Connor in the announcement. "There is now a greater urgency to pass FHA reform legislation that would allow FHA to implement new flexible downpayment programs for borrowers."

MBA says 88 percent of downpayment assistance users were first-time homebuyers, exceeding the FHA average of 79 percent, and that over 20 percent of downpayment assistance users were African-American families, compared with 13 percent of the FHA portfolio in general.

The ruling reportedly holds that downpayment assistance nonprofits who receive funding from sellers to provide dowpayment assistance for borrowers do not operate exclusively for charitable purposes and therefore do not qualify as 501(c)(3) organizations because they confer more than an incidental benefit on "private interests."

"Under IRS reasoning, the substantial benefit received by the home sellers that contribute to the [downpayment assistance] overshadows the organizations' charitable purposes," MBA said.

Because FHA regulations state that entities providing gifts to borrowers for downpayments cannot have an interest in the sale of the property, the IRS does not recognize funds from these downpayment assistance programs under 501(c)(3).

"Thus, going forward, mortgagees will likely have to treat [downpayment assistance] from ... nonprofits not recognized by the IRS under 501(c)(3) as a inducement to purchase which will have to result in a dollar-to-dollar reduction in the sales prices," MBA added.

Recently, a federal court barred Partners in Charity Inc. from falsely promoting that sellers participating in its downpayment assistance program could claim the funds as deductible charitable contributions. This because the administrative fee and the reimbursement sellers agreed to give Partners for the downpayment assistance it provided for borrowers who purchased the sellers' homes did not proceed from "detached and disinterested generosity," but rather to "facilitate the sale of the seller's house."

MBA noted passage of the Expanding American Homeownership Act of 2006 is vital. Among the provisions of the legislation is FHA flexible authority to introduce new products and program changes, such as a flexible downpayment program.

"MBA hopes that Congress will not leave this year without making this critical amendment to FHA's operating statutes and allowing them to continue to serve the American home buying public," O'Connor said.