National Housing Law Project Housing Law Bulletin

The Rural Housing Service (RHS) issued an Administrative Notice (AN) on August 4, 1998, in which it advised all Rural Development (RD) staff that it will begin to report to the Internal Revenue Service (IRS) the names of borrowers who receive assistance under the agency's compensation for construction defects program as well as the amount of assistance that they receive. RD AN No. 3407 (1924-F) (Aug. 4, 1998). The report will be made on IRS Form 1099-G, "Certain Government Payments" and the amount will be shown on the form as a grant. The AN further advises RD staff that they are to advise borrowers who are applying for construction defect compensation that RD has determined that compensation for construction defects may be a grant for income tax purposes and that it will be reported to the IRS. Ironically, the notice goes on to state that the "question of whether or not an amount constitutes taxable income may only be answerable by the IRS. If you have any questions please consult your tax advisor." Normally, grants are considered taxable income by the IRS. The RHS compensation for construction defects program has been in existence since 1977. Authorized by Section 509(c) of the Housing Act of 1949, 42 U.S.C.A. § 1479(c), the program was modeled after a comparable HUD program. It was intended to provide homeowners whose homes were financed by RHS under its Section 502 single-family home loan program with compensation for major structural or health and safety defects found to exist in their newly constructed homes within 18 months of sale or completion of construction. RHS and its predecessor, the Farmers Home Administration, have not been particularly fond of the program and have often placed barriers in the way of borrowers seeking compensation. Total claims for compensation have been relatively small.

It is not known what prompted RHS to institute this reporting process more than 20 years after the program's initiation. However, it appears that the move is both unnecessary and pernicious.

The purpose of the Section 509(c) program is to compensate purchasers of newly constructed homes that are defective and potentially hazardous. It was designed to protect borrowers who purchase and finance what was supposed to be a decent, safe and sanitary home — indeed one that was inspected by Rural Development staff to ensure that it met those standards — but, instead, receive a home that has major structural defects or conditions that make the home unsafe for health or sanitary purposes. Thus, in fact, the borrower received a home that was worth substantially less than what he or she paid. Under RHS regulations, before a borrower is eligible to receive compensation from RHS to repair the defects, the borrower is required to pursue the contractor or seller to make the repairs.¹ If successful, that is, if the contractor or seller makes the necessary repairs, the borrower would not be required to report the value of the repairs to the Internal Revenue Service or pay any additional taxes. The borrower was simply made whole and did not receive more than he or she was entitled to receive for the purchase price that was paid. This result is very much akin to an individual who is injured who recovers a tort settlement from the wrongdoer. That portion of the tort recovery intended to compensate the injured person for his for her damages is not taxable.

An argument can be made in the RHS context that the agency is the wrongdoer, by failing to properly inspect the home and ensure that it is decent, safe and sanitary.² But RHS has always rejected that position and, undoubtedly, would contend that its agreeing to pay for the repair of the defective conditions is not intended to make the borrower whole for the agency's wrongdoing.³ Nonetheless, RHS can both avoid the wrongdoer characterization and relieve borrowers from having to pay income tax on the value of the compensation for construction defects. Under RHS regulations, a borrower who is unsuccessful in receiving relief from the contractor or seller may be asked, as a condition of receiving assistance under Section 509(c), to assign to the agency the claim for damages against the contractor for failure to properly construct the home or repair the damages if recovery is reasonably possible.⁴ Because a borrower gives up his or her claim against the contractor in exchange for receiving the RHS compensation, a strong argument can be made that, in fact, the borrower is not receiving taxable benefits from the agency because the value of the compensation is equal to that of the claim against the contractor. RHS therefore should have made an exception for borrowers who assigned their rights to the agency and could have avoided the issue altogether by requiring all borrowers who receive compensation to assign their claims to the agency.

The impact of the agency's action is likely to discourage borrowers from seeking assistance from RHS. Most RHS single-family home loan borrowers have low incomes and are not likely to be tax experts. Consequently, when a borrower who seeks assistance from the agency is advised that the amount of assistance will be reported to the IRS as a grant, the borrower may rightfully believe that he or she will be taxed on the amount received. Even at an 18-percent tax rate, which is likely to be the applicable rate for many RHS borrowers, the tax consequences of a $20,000 to $30,000 grant will be between $3,600 and $4,800, an amount most borrowers are not likely to be able to easily pay, much less afford. Consequently, potential participants in the Section 509(c) program are likely to forego the agency's assistance.

RHS' advice to borrowers that they should consult their own tax advisors for assistance is also preposterous. It is highly doubtful that most borrowers use any tax advisors in preparing their tax returns. Moreover, even if a borrower were to consult a tax advisor, unless that individual was familiar with the purpose and structure of the Section 509(c) program and the fact that the borrower may have assigned his or her rights to RHS, it is doubtful that the advisor would provide the borrower with correct information.

Moreover, it is not clear why the agency did not consult the IRS or the public in making its determination, choosing instead to implement its decision by way of an Administrative Notice.

Copies of the Administrative Notice are expected to be available on the Internet at www.rdinit.usda.gov/regs/an list.html. n

¹  7 C.F.R. § 1924.265(a)(5) (1998).
²  See Park v. United States, 517 F. Supp. 970 (D. Or. 1981); see also Block v. Neal, 460 U.S. 289 (1983); but see, Moody v. United States, 774 F.2d 150
(6th Cir. 1985).
³  See 7 C.F.R. § 1924.9 (1998).
⁴  7 C.F.R. § 1924.276 (1998).