Equity stripping is the process of encumbering an asset with liens as a means of protecting the asset from future creditors.
Historically, it is one of the oldest asset protection strategies.
While the process itself can take several forms, the end result is generally the same—the asset is saddled with enough debt senior to a creditor’s claim that even if the creditor went through the trouble of forcing a sale of the asset, they would recoup nothing.
As defined by the Uniform Fraudulent Transfers Act (“UFTA”), a lien is “a charge against or an interest in property to secure payment of a debt or performance of an obligation, and includes a security interest created by agreement, a judicial lien obtained by legal or equitable process or proceedings, a common-law lien, or a statutory lien.”A properly perfected lien will, with a few exceptions, take precedence over all future liens as long as it is in effect. If all of a property’s equity is attached to existing liens, then all future liens placed on the property will be practically worthless to the creditor and discourage or prevent them from trying to seize property that has little or no equity. This would include a tax creditor.
Sometimes equity stripping is the only viable means of protecting an asset. For example, financed property may not be transferred into a limited liability company (“LLC”) or similar entity without triggering a loan agreement’s “due-on-sale” clause. If the clause is triggered, then the lending institution typically reserves the right to accelerate the loan, making the entire balance payable within a certain number of days. Another situation where equity stripping is desirable is protection of a personal residence. Under §121 of the Internal Revenue Code, a property that is a person’s home for two years in any five-year period qualifies for an exemption on gain if the property is sold. Although placing the home in a single member LLC or other entity with “disregarded entity” tax status will preserve this exemption, placing the home in a limited partnership or multi member LLC will not.
However, as with all aspects of asset protection, there is a right way and a wrong way to perform equity stripping—and in this case failing to equity strip properly will run the debtor, and anyone who assists them, afoul of fraudulent transfer laws.
First, the lien cannot be “bogus.” While that sounds like common sense, it is a very common, and illegal practice. The lien is “bogus” if the owner of the target asset receives no compensation in exchange for granting the lien. According to the Uniform Fraudulent Transfer Act, any transfer that occurs with no exchange of equivalent value is highly susceptible to a fraudulent transfer ruling, meaning the lien will likely fall apart if challenged in court.
However, not all friendly liens are “bogus.” If a friendly party gives you an actual loan that is equivalent in value to the lien, for example, and he is not an “insider,” as defined in applicable fraudulent transfer law, then the lien may well survive court challenge. That assumes that a debtor can find a friendly person or business that is willing to loan he/she money on friendly terms (keeping in mind that all interest payments the debtor makes to their friend, will be taxable income to the lender).
Second, in keeping with one of the paramount rules of asset protection—late planning is detrimental—the lien must occur significantly in advance of any legal proceeding so that it does not appear to have been created simply to thwart creditors. The closer in time to the proceeding that the lien (or any other form of asset protection) takes place, the more likely a court will hold that the transfer was done not for a legitimate business purpose, but rather to solely evade creditors—and therefore be set aside by the court. Should a bogus lien occur shortly before a creditor threat arises, a good creditor’s attorney would have little problem obtaining a court ruling to invalidate the lien. And, the debtor may be exposed to criminal liability also for making a ‘fraudulent transfer’.
While the courts highly scrutinize equity stripping due to the ease of potential abuses, there are many perfectly legitimate ways to strip equity to protect assets. Although equity stripping can be an effective means to protect assets, it requires a lot of knowledge and skill to implement properly. Poorly designed or implemented actions are often either vulnerable to fraudulent transfer rulings, or are costly from a tax and/or economic perspective.