Equity Stripping Articles

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What Is Equity Stripping?

Equity Stripping is a strategy designed to reduce overall equity in a property. Equity stripping strategies can be used by debtors as means of making properties unattractive to creditors.

The idea behind equity stripping as an asset protection strategy is that through reducing equity in a property, creditors are discouraged from pursuing the property to sastisfy claims against the debtor. By giving another party a claim against a property, an owner can retain use of the property as well as control over cash flow while simultaneously making the property an unattractive asset to any creditor who may otherwise attempt to enforce a  judgment against the property owner.

Conventional Equity Stripping Formats

Two of the most common equity stripping strategies are

  • spousal stripping and
  • home equity lines of credit (HELOC).

Spousal stripping is the process of shifting the title of a property into the name of a debtor’s spouse. This strategy allows a debtor to file a quit-claim to the property in the name of their spouse, who presumably has no debt or little debt. While this strategy is not a bulletproof method of protecting property from creditors, it is a simple and accessible asset protection strategy for many homeowners managing significant debt.

Home equity lines of credit enable the owner to use the equity in their home as a line of credit. A HELOC is a sort of a second mortgage, using the home equity, or the difference between the value of the home and the remaining mortgage balance, as the collateral on a line of credit. Funds in a HELOC function in similar ways to a credit card. The bank issuing the HELOC to a homeowner will provide a number of avenues for using these funds, including a bank-issued credit card tied to the account. While HELOCs offer some attractive benefits, including variable interest rates and, in some cases, low or no closing costs, they can also put borrowers in jeopardy of losing the equity in their home.

Example of Equity Stripping

Suppose a home is worth $500,000 and the owner can claim an exemption of $100,000 from the property. Without a mortgage, a creditor to the home owner could place a lien on the home amounting to $400,000, i.e., the remaining less than the homestead exemption. With a $400,000 mortgage, however, the creditor will not be able to place a lien for that amount due to the security interest that the lender of the mortgage is entitled to.

Equity stripping combined with an  Private Intra-Entity Equity Exchange Plan (“PIE-EEP”)

Depending on the situation and the type of assets involved, an PIE-EEP can be used by itself or in combination with other techniques.

An PIE-EEP is designed to protect equity in real estate or business assets from a potential future claim. Remember, normally asset protection planning strategies, with some exceptions, must be in place BEFORE a claim arises.

Real Properties

Real estate assets are a favorite target for creditor’s attorneys as an asset to seize to satisfy a judgment or may in and of itself be related to the arising of a claim. As a tangible immobile asset, real property is inevitably always vulnerable to a lawsuit. During the last 10 years there has been a dramatic increase in the value of most properties. A significant portion of your net worth may have shifted from stocks to real estate equity.

Professional Practice Accounts Receivable and Equipment.

Physicians and other professionals have practice value inside their practice in the form of leviable assets such as accounts receivable and equipment.

A patient or employee lawsuit against the practice exposes these assets to risk of loss. Without those assets, there is no practice.

Business Owner Assets

Business owners may have inventory, equipment, patents, and trademarks in addition to accounts receivable. If these assets have value it is intelligent and sensible to protect them from the risks of the business creditors.

One strategy is to have those assets owned by a different entity than the one conducting business operations, which then leases and licenses those assets to the operating entity.

However, in those situations where movement of an asset or having them owned by another entity is impossible or impractical or too late, equity stripping within an ERP can move the equity or the value of an asset into a protected position. Ownership of the underlying property remains the same and need not be transferred. This is a clear advantage in many situations:

  • Those who own multiple properties can avoid the inconvenience and cost associated with forming several Limited Liability Companies.
  • An ERP protects the equity in a property from a claim arising out of the property itself (an “inside” liability).This cannot be accomplished with an LLC or any other entity.
  • An ERP avoids a transfer of real estate ownership and potential problems with increased property taxes, transfer taxes and due on sale clauses from a lender. Accounts receivable usually cannot be transferred out of a professional practice because of accounting problems and insurance company restrictions.An ERP is the only technique available to insure the protection of the cash flow cycle of billing and collection.
  • Similarly, the inventory, equipment and intellectual property in a business are essential for operations and future success. An ERP is designed to avoid disruption or loss of the business by protecting these assets.
  • Valuable but unproductive equity in real estate, accounts receivable and business property can be leveraged for business or investment purposes. These dormant assets can be put to work in an ERP, enhancing asset protection and generating additional income.

California exemption from creditors law protects a significant but not necessarily sufficient amount of home equity from your creditors via “homestead laws.”

In California it can often make sense from an asset protection standpoint to pay off the mortgage rather than invest in a taxable account exposed to your creditors.

Equity stripping is done in states like California with relatively weak homestead laws. Pursuant to this concept, you borrow your home equity out and place it somewhere else that is protected from creditors such as retirement accounts (such as an IRA or a California Retirement Trust) or whole life insurance.

If retirement accounts are protected but whole life insurance is not, possibly you can borrow against your whole life cash value (or surrender the policy) and use it to max out retirement accounts or do Roth conversions.  The variations are endless and generally come with a downside such as paying interest. Given the very low risk of a judgment above policy limits, it’s tough to recommend most of these techniques for any but the truly paranoid.

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[4], 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.