Flood Insurance Escrow for a Dwelling that Will be Torn Down After Closing and a Commercial Building
A bank is closing a commercial loan secured by four lots located in a Special Flood Hazard Area (“SFHA”). An inn and restaurant are located on one lot. Two lots are vacant and will have a parking lot built on them. The fourth lot has a house on it that will be torn down soon after closing for a parking lot. An escrow account will be set up for the payment of taxes. Is flood insurance is required for the house on the fourth lot? If flood insurance is required for the house, must the premiums for it be included in the escrow account? And must the premiums for the flood insurance on the commercial property be escrowed for as well?
Under the flood rules, a bank shall not make, increase, extend, or renew any loan secured by improved real property unless the building securing the loan is covered by flood insurance. The amount of insurance must be at least equal to the lesser of the outstanding principal balance of the designated loan or the maximum limit of coverage available for the particular type of property under the Act. 12 CFR Section 339.3.
In this case, the intention is to tear down the house on lot 4 soon after closing. The flood rules, however, do not make an allowance for this. There are only two exceptions from the mandatory flood insurance requirements: (1) if the property is state-owned and covered under a policy of self-insurance satisfactory to the director of FEMA; or (2) if the original principal balance of the loan is $5,000 or less, and the original repayment term is one year or less. 12 CFR Section 339.4.
The bank must therefore require the borrower to obtain flood insurance and maintain that insurance until the house is torn down.
The flood rules also provide that if a bank requires the escrow of taxes, insurance premiums, fees, or any other charges for a loan secured by residential improved real estate that is made, increased, extended, or renewed, the bank shall also require the escrow of all premiums and fees for any flood insurance required by the flood rules. 12 CFR Section 339.5. Since the loan is secured by the house, and since the bank is escrowing for the payment of taxes, it must also escrow for the payment of the premiums for the flood insurance covering the house.
The question of whether the flood insurance for the commercial property on lot 1 must also be included in the escrow is a harder one to answer. Generally, the determinative factor in the coverage of the escrow requirement is the purpose of the building. If this loan was secured solely by the commercial property, for example, the premiums for the flood insurance covering it would not have to be escrowed for under the flood rules, since it is not residential improved real estate. The trigger for the escrow requirement here is the escrow required for taxes and the nature of the house on lot 4 as residential improved real estate.
The exact wording of the flood rules in this instance is ambiguous, however. Once the escrow requirement is triggered, it applies to “all premiums and fees for any flood insurance required under § 339.3.” Since flood insurance on the commercial property is required under Section 339.3, arguably it must be escrowed for even though it would not otherwise have to be, but for the trigger having been pulled.
The bank might escrow just for the flood insurance on the house and argue that the requirement does not apply to flood insurance on a commercial property. Given the ambiguity in the wording of the regulation and the severity of the penalties for noncompliance with the flood rules, a more conservative approach would be to escrow for the flood insurance on the commercial property as well as for the house.