By: Randall A. Denha, Esq.
Once you have protected assets, particularly real estate, by placing them into an asset protection entity or vehicle, the work is only half done: You have made it hard for the creditor to get to the asset. However, the asset is still worth something because the ownership interest, the equity itself, has not been stripped out of the asset yet. A creditor can still, in some circumstances and given enough time, navigate the layers of protection you have built or potentially make claims of fraudulent transfer and attack the asset. If it is a valuable asset, the creditor might decide the fight is worth fighting.
There are lots of little things that you can do to make it less likely that someone can take all your money away in a lawsuit, whether malpractice-related or otherwise. Sometimes these little things are cheap and easy and without significant adverse consequences, like titling your house properly. Other asset protection techniques are expensive and involved, and may decrease investment returns or increase your taxes. You definitely want to think twice before implementing these, and really weigh how much that asset protection is worth to you.
One asset protection technique you should be familiar with is the concept of “equity-stripping.” This basically means taking money from a position where it is exposed to a lawsuit, and putting it somewhere where it isn’t. There are lots of variations, but here are a few examples.
For example, in many states only a portion of the equity in a home is protected from creditors. Since some people have more equity in the home, there is money that is still exposed to lawsuits that could arise. Many people carry general liability and homeowners insurance that may cover any loss, but it’s possible that liability could exceed insurance and one may to sell the home to meet a judgement. In order to eliminate this risk, the remaining equity in the home could be “equity-stripped” out of the home. This is generally done by taking out a loan, by either refinancing the home or taking out a home equity loan. What is then done with the loan proceeds? They could then be placed into an exempt asset such as a contribution to a 401K or Roth IRA, buying cash value life insurance, or perhaps use it to buy an asset in a spouse’s name. The point is that it is no longer exposed to creditors, so not only is the equity still maintained, indirectly, but one can’t be forced to sell the house. The downside, of course, is that there may be refinancing fees, interest on the loan, and a higher rate on the loan. Another option is to simply pay down the mortgage instead of buying life insurance, and certainly better than buying another asset!
Other variations of equity stripping include but are certainly not limited to any of the following:
- Mortgaging the assets, creating a mortgagor’s lien on the asset.
- Opening a Home Equity Line of Credit.
- Locating a friendly entity to extend a bona fide mortgage or second mortgage. (Generally, commercial lenders will not lend up to the entire value of the property, and will not be a subordinate lienholder. Friendly entities might, especially if owned by you.)
- Contracting a commercial bank to mortgage the property, and having a friendly entity buy the lien and the right to receive payments off the bank. (The bank will require a processing fee for handling the payment.)
- Creating a limited liability entity owned by the asset owners as well as a different outside owner to ensure or reduce the chance of all the owners being debtors of a common creditor.
- The limited liability entity needs a legitimate business purpose to function in most state’s law, such as investment or an operating business.
- In exchange for the ownership interests, the owners sign promissory notes to the limited liability entity for the value of the assets stripped, and the limited liability entity secures the repayment obligation with a lien.
- Finding an existing limited liability entity business, and buying most of the ownership interest out in exchange for a promissory note for the value of the house, with the repayment obligation secured by a lien against the asset.
- Leaseback arrangements, especially to protect commercial and business assets.
- The technique can also be used in conjunction with estate planning tools to shift wealth outside of an owner’s taxable estate by, for instance, having a family trust issue the loan to the individual or entity so that interest income and fees are earned by the trust.
Another example is the worry some doctors have in the equity in their practice, usually in the accounts receivable, but also theoretically in the building, property, or medical equipment. You can take out loans against all this stuff, stripping away the equity and reducing your liability exposure. You can even start another company that owns your practice, or just your equipment, and lease it back to yourself. This is often called “factoring” the accounts receivable. Sometimes you don’t even increase your costs by doing this. For example, you could take out a loan against the accounts receivable and pay off the real estate loan with it (but have the real estate owned by a separate entity than the practice.)
Real estate can be protected to different degrees in different states. Each state laws vary in this regard.
While equity stripping is a valuable tool, it does have disadvantages, some of which include:
- Most types of property are not exempt, or have very low exemption levels, under state debtor/creditor and federal bankruptcy laws. As a result, creditors may force a sale of the property even if another entity has a first security interest. This outcome is more probable if the creditor believes a sale will yield a recovery. Thus, failing to continually strip excess value runs the risk that the asset may nevertheless be lost.
- Equity stripping exposes the owner to being “under water” if the property depreciates below the outstanding balance of the loan. This is more likely with aggressive equity stripping in relation to assets which are in volatile markets.
- The assets in which the Equity are invested could decline in value (some cases significantly) or yield a lower return than interest charged on the loan. In such cases the owner could be in a worse position (particularly if no creditor materializes) than if equity stripping had never been undertaken.
Equity stripping is one technique to effect asset protection. In practice, equity stripping can take many forms and be used in creative ways to leverage and protect assets. As with every alternative, however, there are trade-offs that require careful consideration.
Reducing the amount of assets exposed to a lawsuit can often be a good idea, and equity-stripping is one way to do so. Consult legal counsel and perhaps even an accountant before taking such a drastic asset protection measure, and remember you have to do it before you get sued for it to do any good as there are a body of laws called fraudulent conveyance to contend with that need to be navigated.