The only thing I’m not sure about is who is the host instance? My understanding is that the host instance is that which the user belongs to.

That’s my understanding too - if you’re a lemm.ee user, and you want to upload to pics@lemmy.world, then when you post, you’re actually posting to lemm.ee/c/pics@lemmy.world. This rule change means that - for the moment - lemm.ee users can’t upload any images directly when making a post, irrespective of where the community is. They’d have to use an external host like imgur.