How do I protect my home from potential creditors? This is a very common question that does not lend itself to a straightforward answer. Many options exist for protecting your home, but the key is deciding on the appropriate strategy. The following are some of the common methods I utilize to protect many of my clients’ most important asset. Note: these strategies are presented in order of protection going from least to greatest.
If you are not familiar with the term, a friendly lien is simply a lien against property you own by a party that is friendly to you. The friendly party is typically a corporation or LLC you have created in a jurisdiction such as Nevada or Wyoming, which allows the use of a nominee to mask your involvement with the business entity. Friendly liens are considered effective asset protection tools because a potential predator, i.e., creditor, that comes along after the friendly lien is in place, may consider the property unworthy of pursuing because of its lack of equity. The friendly lien essentially “encumbers” a property, i.e., ties it up, and makes it look less attractive.
For predatory lawyers, any lawsuit is a numbers game. The decision to pursue litigation or collections is an economic decision. If the economics are not beneficial because the property appears fully encumbered, the creditor may not pursue the case, or will certainly accept less. Thus, the friendly lien is designed to make your home appear fully encumbered to outsiders looking at your residence. However, this technique is purely a smoke screen and does not actually protect your equity unless you have borrowed the money from your LLC. Most people who utilize the friendly lien strategy never actually borrow the money thus, in the face of an aggressive creditor, their equity is left exposed to attachment.
Personal Residence LLC
Limited Liability Companies are recognized for providing excellent asset protection for rental real estate. However, when it comes to protecting a personal residence these benefits do not necessarily translate in the same manner. Unlike a rental property that produces income, is held for long-term appreciation, and is treated like a business, a personal residence only satisfies one of the aforementioned characteristics. Should this dissuade you from placing your personal residence in a LLC? The answer depends on where you reside and your expectations.
Placing a personal residence in a LLC should be carefully considered and only done so with the assistance of someone knowledgeable in taxation of LLCs. Consider this example: You are married and live in Colorado with a homestead exemption of only $60,000. If you placed your residence in a LLC wherein both you and your spouse are owners in the company, then you may have unknowingly forfeited your 121 home sale exclusion (capital gains exclusion for a primary residence) when the property is later sold. An LLC with two members must be taxed as a partnership (an exception exists for married couples who live in a community property state – Colorado is not) thus, for federal income tax purposes you are no longer considered to be the owner of a residence. The property is now an investment and will be listed on your Schedule E.
Should you ignore this strategy all together? Not necessarily. Think of it as a roadblock or deterrent to aggressive creditors. If a creditor wanted to lien your residence, the creditor would need to convince a court to dismantle your LLC. This is costly for a creditor and will thwart him of a quick payday. If you elect to use this strategy, you should set up your LLC so it is disregarded for federal tax purposes to preserve your 121 exclusion. A disregarded LLC is a LLC with only one member (in a community property state husband and wife are treated as one member for tax purposes). Thus, if you are married and do not live in a community property state, one spouse will need to give up ownership or each of you will need to create a LLC to hold your 50% ownership in your residence.
The homestead exemption, which applies to your place of residence, is one of the most important exemptions you can claim. The homestead exemption is usually stated as a percentage or dollar amount of the value of your personal residence that is exempt from creditors. The amount varies widely from state to state. In addition to Florida, Minnesota and Texas, Kansas, Iowa, and South Dakota provide debtor friendly homestead exemptions, allowing you to write off an unlimited dollar amount related to the value of your home.
Qualified Personal Residence Trust “QPRT”
A QPRT is an irrevocable trust you create to hold your personal residence for a term of years whereupon at the trust expiration the property passes to your children. You might be asking yourself why I would want to set up a trust to give my house to my kids? The short answer is to move it beyond the reach of creditors. Think of a QPRT as an asset protection trust with one goal in mind: protecting your residence. When the property is transferred into the trust you retain the right to occupy the property but legal title is held by the trust for the benefit of your children. If a judgment is entered against you or your spouse, a creditor is unable to attach the property because a completed gift of your house was made when you established the trust (the trust is irrevocable).
Another attractive feature of this trust is the complete control it gives you over the residence. During the trust term you have the ability to sell your residence and purchase a replacement and yes, section 121 capital gains exclusion will apply. If you are not in the market for a new residence because you desire to travel abroad, you can sell your residence and use the income for living expenses. Keep in mind that if you discuss this strategy with a local attorney he might tell you a QPRT is only viable provided you do not outlive the trust term. This is because the QPRT is an estate planning tool to reduce the value of a person’s estate by removing the value of the residence. This benefit is only conferred if the trust distributes the residence to your children prior to your passing, otherwise its value is included in your estate for estate tax purposes. For most of my clients, estate tax is a secondary concern to asset protection hence, most opt to create a lengthy trust term to maintain control for as long as possible.
I.R.C 7702 Equity Removal Plan
The equity removal plan centers on statutory protections similar to the homestead strategy, but in this instance you remove your home equity and place it in a statutorily protected investment account. The plan works as follows:
Kevin and his wife own a home in New York with a fair market value (FMV) of $700,000 with $325,000 in debt. Under New York law, $275,000 of Kevin’s $375,000 in equity is exposed to his creditors. To protect this equity Kevin will obtain a home equity line of credit (not a refinance) and remove $275,000 of equity from the home over a five year period (which creates a 85% debt to value ratio on the property). Kevin will place the funds into a 7702 plan, which is an investment account with a 1% guaranteed rate of return on the cash value and its growth pegged to the S&P 500 index locking in the gains annually. Furthermore, if Kevin needs this money for any reason he can borrow from his plan tax-free.
Kevin’s 7702 plan is statutorily protected under New York law so Kevin’s creditors could not gain access to these funds and the remaining home equity, $100,000, is also protected under New York’s homestead law. What also makes this plan superior to the other plans is the cash withdrawn from 7702 is also protected.
Which is Best
If you are wondering which plan is the best for your residence, I suggest you contact me to set up a consultation because each plan has its strengths and weaknesses. My personal favorite is the 7702 Equity Plan. The 7702 Equity Plan not only provides a guaranteed return on cash trapped inside of your home, it also provides a source of income protected from creditors. The Homestead and QPRT strategies each provide great protection for your house but neither will protect cash withdrawn from these plans, i.e., if you take out a home equity loan against your homestead, the money you withdraw is reachable by a creditor. The 7702 Plan allows a homeowner to have access to equity in times of trouble without fear of a creditor taking these funds. Sometimes I will ask people if they like the taste of cotton. I get a blank stare until I explain to them that in the event of a lawsuit, if their equity is not protected in a liquid form, their future diet will consist of eating their couch cushions because their creditor will have all of their food money!