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Protecting Your Home From Creditors

Many clients ask me how to protect their homes from creditors.

Among the reasons for this, is that for many people, the family home  is not only where they live, but also  represents the largest source of wealth and personal savings.

Large  increases in housing prices have made protecting the home from lawsuit risk a key issue in asset protection planning. Clients cometo us with substantial equity in their residence and may own one or several vacation homes and rental houses in addition to that.

A corporation or LLC is not the optimum type of entity to own a house. First, stock is easily seized by creditors. Second, homes owned by LLCs, other than single member LLCs, lose the IRC 121 gain exclusion benefit because that exclusion only applies to individuals and certain types of trust.

So, what should we do to protect these valuable properties from the risks of a potential lawsuit? The question  is how to protect the family home from lawsuit risks. Note:  a residence is treated differently for asset protection and tax purposes than a rental property.

Particular Aspects and Issues

A residence has certain unique legal and tax attributes which are unlike any other type of property. Homes have a distinct set of tax and legal considerations which don’t apply to any other type of property. Rental real estate has its own characteristics and savings and pension are treated still differently. To protect the home from liability risk several key factors must be considered.

Tax Benefits

There are significant tax advantages from home ownership although these benefits have been weakened by the by our ever changing tax laws.

Interest Deductions

For homes you live in for a certain period,  you are entitled to a mortgage interest deduction up to the limit on deductions.

Home Sale Gain Exclusion

If married, and you own and use as your personal residence for 2 out of the previous 5 years, (with some exceptions to benefit taxpayers), you can exclude up to $500,000 of gain (for a married couple). The gain exclusion if up to $250,000 for a single person.

Property Taxes Deductibility

The deductibility of property taxes is now subject to the overall $10,000 limit for deductions on state and local taxes. The requirement for any deductions for tax purposes is that you are the “owner” of the residence. If we create a plan which removes you from ownership these tax benefits can be jeopardized. So care must be exercised in the planning stages to choose the appropriate strategy to avoid inadvertently losing the available tax advantages. To make that happen, the trust we design and preparation will be what is called a ‘grantor’ trust under tax law. There are ways to plan around that $10,000 limit through the use of a partnership or LLC.

Real Property Taxes

Subject to a 2% maximum increase in assessed value, California law prohibits an increase in assessed value so long  you or certain types of trusts own your home. For example, California does not allow a reassessment to a higher value unless there has been a “change of ownership” of the house. This law prevents the county assessor from raising your property taxes every year when the house increases in value subject to the 2% maximum annual allowed increase in assessed value. Those who bought their homes many years ago, for $500,000 would not be able to afford to pay property taxes based on a new valuation of $1 million. California and other states prohibit a change in the property taxes unless the house is sold or there is some other “change in ownership” which can include a transfer to a trust that does not qualify for the exemption or other entity. Any strategy for protecting your home must avoid triggering a new property tax assessment following a transfer of title, by carefully following all of the rules.

Continued Enjoyment

It will be important that you maintain the ability to live in your home even when it is in the asset protection plan. The situation is a little different with rental real estate or retirement savings which you may not need to use until some time in the future. Clearly, you need to live in your home now but you don’t necessarily need to use the income from your investments while you are working. There is no question about it, when we deal with an asset that is reserved for current use, protection of that property is more difficult and requires considerably more thought. Whenever we do our planning we have to take this fact into account.

Homestead Protection

California law provides  certain legal protections for your homes. Further legal protect is necessary only if you have equity which exceeds the amount protected by state homestead laws.

Infeasible Plans

As I mentioned above, techniques which can be used for other types of assets such as investment real estate and savings are generally not effective for protecting the family residence. For example, if a family limited partnership or limited liability company is used, the tax law or the IRS has ruled that some or all of these tax advantages may be lost. In addition, if a property within an FLP is reserved for personal use, the protection offered by the FLP might be challenged in a future lawsuit. Partnerships have a business purpose if they are to be respected by the IRS and the courts.

Gifting the home to ones spouse-will preserve the tax benefits- but is unlikely to accomplish anything on the asset protection side.

Solutions that Work

In light of the above,  the question in asset protectionare

how to protect equity, above the homestead amount,
while preserving
the tax benefits and t
he continued right to use and enjoy the house.

Tax Issues

First, let’s review and analyze the tax issues in the trust context.

Some trusts are treated by the tax law as if they do not exist. This type of trust is known as a “grantor trust” and if certain language is used in the trust document the IRS will treat you as the owner of the property, not the trust. That’s good and it is what we want for our purposes. We want a legal trust that is respected for protection purposes but that is ignored for taxes. That way we are assured that we’ll retain all the tax benefits. So, our first requirement is that the trust we use is treated as a “grantor trust.” If the trust is a grantor trust, then the tax benefits including the gain exclusion are preserved.

Trust Asset Protection Issues

After resolving the tax issues, we consider the asset protection issues.

To achieve worthwhile protection for the residence it is important that your legal rights concerning the house are limited in some manner. If you maintain the full range of ownership rights, it is likely that a judge would order you to turn over the property to a plaintiff with a judgment against you. In other words, to the extent that you have unrestricted power to do anything you want with your home, it can be seized in a collection action. Thus, that must be avoided.

The key to protecting the home is to limit your rights in some manner so that there is nothing legally available which can be reached. If your ownership of your home changes from full and complete to something less, your interest may have no value to a prospective creditor.

How can you limit your rights in an acceptable manner for these purposes? I say acceptable because it is easy to fully protect your home if you want to give it away to your children and not live there anymore. However, giving it away does not protect it from the donee’s creditors, and may run afoul of certain other laws.

Personal Residence Trust (PRT)

A Personal Residence Trust is a broad generic term I use to descirbe a trust to hold property and apply restrictions which protect it against possible loss. This type of trust is designed to be ignored for tax purposes so that no tax issues are created and the tax benefits are preserved. There are many different formats and strategies which can be used for creating this type of trust, depending upon the particular circumstances of the case.

One popular technique is to provide in the PRT that your children or other family members take ownership of the house after a certain number of years. The trust reserves to you the right to live there for a period of time-perhaps 10 or 20 years. In addition to powerful asset protection advantages this arrangement, depending on the exact terms, may provide excellent estate tax benefits by freezing the value of the house at its current amount and removing it from your taxable estate. The period of years and the important terms can be modified or tailored to meet most circumstances.

Sometimes we reverse this arrangement if the circumstances are appropriate. Rather than reserving a right to live there for a period of years, the PRT can provide that the home belongs to the trust but can be leased back to you for a period of years. Although you would pay rent to the trust, the usual tax benefits would apply because of the grantor trust rules. At the end of the term of the lease, full ownership could be returned to you or passed to your children. It can go either way, depending upon your view of any future potential liability you may have.

Create a Lien to Strip Equity

In a slightly different view, the PRT could be provided with an option to purchase or a right to exercise some other authority over the property within the trust. As an illustration, rather than a recommendation, assume your home is worth $1 million with a loan of $500,000. A Personal Residence Trust is created which grants the trust an option to purchase the property for the loan amount, any time within the next 15 years. The option agreement is recorded and acts the same as a lien on the property. The equity in the home cannot be seized by a successful plaintiff, since the home itself is subject to the option to purchase for the $500,000 amount. Under this arrangement you can live in the house without restriction and subject only to whatever terms are provided in the option agreement. There are a number of issues which must be addressed in this type of strategy but this illustration gives you an idea of the direction that planning can be taken.


Protecting the family home from the risk of lawsuits requires consideration of income tax and local property tax issues as well as your State homestead law. A Personal Residence Trust may provide a viable solution for many of the problems which typically arise when we are dealing with a home.

For those who believe that they have some degree of lawsuit exposure and who have substantial equity in their home, one or more of the available strategies with the Personal Residence Trust may be a viable course of action. As we always suggest, the particular circumstances of your case and developing a plan which is appropriate for you is a matter which must be discussed with us.

Types of Asset-Protection Trusts

There are many types of asset-protection trusts. Trusts that serve in one way or another to shield assets from creditors include

  • spendthrift trusts
  • discretionary trusts,
  • support trusts, and
  • personal trusts.

Furthermore, it is possible to cause a beneficiary’s interest to change from spendthrift to discretionary or some other type of interest; that is, a shifting-interest trust.

An otherwise protective trust can be judicially invalidated under certain circumstances, for instance, if a trust is found to violate public policy or to have been created for fraudulent purposes (including facilitating a fraudulent transfer). Prob C §15203.

Certain types of claims will more readily pierce protective trusts—

  • claims for spousal or child support (Prob C §15305),
  • basic necessities of the beneficiary (Prob C §15306), and
  • certain claims of state and federal government.

The beneficiary’s behavior can also affect the protection of trust property. Specifically, damages caused by a beneficiary in the commission of a felony may be satisfied out of trust property if various conditions are satisfied. Prob C §15305.5. Furthermore, the asset-protection aspects of each type of trust are subject to the prohibition against self-settled trusts.

Prohibition Against Self-Settled Trusts

Creditors of a settlor who funds a trust for the settlor’s benefit can reach trust assets to the extent of the settlor’s power of revocation. Prob C §15304(a).

Self-settled trusts include the revocable living trusts formed by many clients for estate planning purposes—these trusts provide no particular creditor protection. A person who provides consideration for a trust, directly or indirectly, is treated as the settlor.

Self-settled trusts are prohibited because it would be a blatant abuse and would violate public policy to allow settlors to establish asset-protection trusts for themselves.

The prohibition against self-settled trusts can arise in a number of estate planning situations. For instance, in a split-interest trust the settlor retains an interest for a term of years; the settlor’s retained interest can be reached by creditors. CCP §709.010(b).

Additionally, withdrawal powers (called Crummey powers)are often employed in connection with estate planning trusts such as irrevocable life insurance trusts. Crummey powers give the powerholder the right to withdraw trust contributions for a period of time after a gift is made to the trust and qualify the gift for the present-interest annual exclusion under IRC §2503(b). Crummey v Commissioner (9th Cir 1968) 397 F2d 82. . When a Crummey power is used, the trust may constitute a self-settled trust to the extent of property subject to the power held by the trust beneficiary having that power.

Alter Ego Doctrine

A trust can also be ignored under an alter ego or nominee theory.

In Adam v U.S. (CD Cal 2011) 2012–1 USTC ¶50,128, 109 AFTR2d 329, aff’d in part and rev’d in part (9th Cir 2013) 112 AFTR2d 132 (unpublished opinion), citing Leeds LP v U.S. (SD Cal 2010) 2011–1 USTC ¶50,152, 106 AFTR2d 5680 (discussing several California cases that recognize nominee status), the district court applied the a six-factor test and concluded that children held title to real property as nominees of the taxpayer after a series of transfers. Therefore, the property was subject to the IRS’  IRC §6321 “secret lien.”

Availability of Trust Assets

A creditor of a settlor of a self-settled trust can reach trust assets to the maximum extent that the trustee could distribute or apply those assets for the settlor-beneficiary’s benefit. Prob C §15304(b). If the settlor transfers a remainder interest to a third party, the settlor’s creditors cannot reach it. If the trustee of a self-settled trust can make principal distributions to the settlor-beneficiary only if income is insufficient for support, then the creditor will not be able to reach principal unless the settlor-beneficiary’s circumstances require invasion of principal. (The creditor would be able to reach the income interest required to be distributed.) DiMaria v Bank of Cal. Nat’l Ass’n (1965) 237 CA2d 254.

Exemptions under California law apply to an interest in a revocable trust. Prob C §18201. An exemption, to the extent necessary, should also apply to the beneficiary’s interest in an asset protection trust. Restatement (Second) of Trusts §149, Comment b (1959); Restatement (Third) of Trusts §56, Comment d (2003) (statutory exemptions for property, such as for homesteads, attach to the equitable interests in property in trust even though legal title is held by a trustee for the debtor’s benefit).

Exceptions to Prohibition
There are exceptions to the prohibition against self-settled asset-protection trusts. Many foreign jurisdictions have adopted special legislation to allow self-settled asset-protection trusts. United States courts have generally not recognized these foreign laws. See, e.g., Marriage of Dick (1993) 15 CA4th 144, 161. Furthermore, a growing number of states have adopted similar legislation, notably Alaska, Delaware, and Nevada.

In IRS Letter Ruling 200944002, the IRS ruled that an irrevocable trust established in Alaska by an Alaska resident settlor would not be included in the settlor’s estate even though the settlor was a permissible distributee of trust property. The ruling noted that there were no circumstances in which the trustee was required to make distributions to the settlor, his estate, his creditors, or the creditors of his estate. Under Alaska law, the settlor’s creditors could not reach the trust property.

These laws generally will not be effective for California residents, although it is possible to move to one of those jurisdictions if and when a creditor problem arises.  One area in which the self-settled asset-protection trust is effective is for retirement plans subject to ERISA. Patterson v Shumate (1992) 504 US 753, 112 S Ct 2242; Gertz v Warner (In re Warner) (Bankr ND Ohio 2017) 570 BR 582. See §26.39.

Notwithstanding the general prohibition against self-settled trusts, the settlor can retain a limited power of appointment over trust assets without compromising asset-protection goals unless (1) the property was transferred in violation of the Uniform Voidable Transactions Act (UVTA) (CC §§3439–3439.14); or (2) the initial gift in default of the exercise of the power is to the powerholder or the powerholder’s estate. Prob C §681.

In contrast, creditors of the holder of a general power of appointment can generally reach assets subject to the power if and when it is exercisable. Prob C §682. Furthermore, creditors of the donor of a general power of appointment exercisable by another in favor of the donor can reach property subject to the power regardless of whether the power is presently exercisable, except to the extent the donor effectively irrevocably appointed the property subject to the general power of appointment in favor of a person other than the donor or the donor’s estate. Prob C §683.