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Homestead
Exemptions
Tenancy by the entireties
Dual
living trusts
Qualified Personal Residence
Trust
Family
Limited Partnerships
Maximum Debt
Foreign
Grantor Trust
For many people, their home equity is their largest single
asset and a major retirement resource.
For most people, their three largest assets are their home
equity, their pension plan and their business. This article
will review the various strategies you can use to protect your home
equity from the claims of future creditors.
Your first line of defense if a creditor seeks to take your
home is the homestead law in your state. If that's not available
or not adequate, you need to check on whether your state permits
married couples to own real estate as "tenants by the entirety".
If you're single or your state doesn't provide that form of protection,
the next step is to explore the benefits of a qualified personal
residence trust. Some advisors advocate putting your home into a family limited partnership - but I disagree due
to tax considerations. Instead, you can borrow against your equity and
put the cash into a FLP. A final resort is to put your home into a foreign grantor trust. For residents
of California, any change in the form of ownership must be considered
in relation to the proposition 13 lid on property tax exemptions.
Homestead
Exemptions
If you live in Florida, Iowa, Kansas, Minnesota, Oklahoma, South Dakota
or Texas, your home may be the best way to protect your assets from
creditors. These states have bankruptcy exemptions that protect your
homestead from the claims of creditors, regardless of the value of your
home. Some states require that you reside in the home at the time you
file for bankruptcy, while others require that you have no other
residence and some states are silent on this issue.
However, various federal laws preempt state law so the
homestead exemption won't protect you from the feds in many cases.
Connecticut, Delaware, Maryland, Pennsylvania and Rhode Island
have no homestead exemption at all. (New Jersey had none but I
understand they have recently changed their bankruptcy laws.) The other
states provide homestead exemptions ranging from $2,500 in Arkansas to
$100,000 in Massachusetts. Each state imposes limits on the amount of
land that is protected by the homestead exemption. Florida sets a limit
of 1/2 acre in a municipality or 160 acres elsewhere. Texas allows one
acre in a city or town and 100 acres elsewhere but that's increased to
200 acres for a family. There are other rules about the homestead
exemption that vary from state to state.
In states with unlimited homestead exemptions, your best form
of asset protection is to use other assets to pay off your home loan.
In most states, you need to be a resident for six months to a year
before the homestead exemption is available, but after that you can buy
a home of any size and thereby convert exposed assets into exempt
assets. However, converting all of your assets into residential real
estate violates every concept of asset diversification. By doing this,
you are exchanging one form of risk for another. Ask the folks in
California if they would want to have all of their wealth tied up in
California real estate.
Even so, if you are faced with an imminent lawsuit, paying off
your mortgage or buying a bigger house may be your only choice if you
live in a state with a generous homestead exemption.
Tenancy by the Entireties
Twenty four states permit a husband and wife to own real property as a
"tenancy by the entireties". With a typical form of joint ownership, the property is subject to
the claims of either spouse. With tenancies by the entirety, neither
spouse can sell the property or any interest in it without the consent
of the other spouse. The creditors of one spouse can't take the
property.
In order to benefit from this form of protection, you need to
exercise substantial care to avoid any unnecessary dual exposure. For
example, if a spouse is not actively involved in your business (or vice
versa), the spouse should not be an officer or director of the
business. Spouses should also avoid co-signing (or guaranteeing) any
obligations whenever possible. Also, this form of ownership does not
protect your assets in the event of a divorce. In addition, if the
property is collateral for a loan, a bankruptcy trustee can then bring
the property into the bankruptcy estate, so it's important that this
type of property be debt free if possible.
In some states, this form of ownership for any real property
held jointly by spouses is assumed, but in other states you must take
special steps to be sure your property is protected. Also, there are
time limits in some states as to how long the property must be held in
the entirety before it's protected in bankruptcy. A few states provide
protection for personal property as well.
The following states provide exemptions for homesteads owned
by husband and wife as tenants by the entirety.
| Alaska |
Arkansas |
Delaware |
Florida |
| Hawaii |
Indiana |
Maryland |
Massachusetts |
| Michigan |
Mississippi |
Missouri |
New Jersey |
| New York |
North Carolina |
Ohio |
Oklahoma |
| Oregon |
Pennsylvania |
Rhode Island |
Tennessee |
| Utah |
Vermont |
Virginia |
Wyoming |
Dual living trusts
Mark Warda suggested a way
that couples can obtain asset protection benefits similar to tenancies
in the entireties in states that don't recognize this form of
ownership. According to Warda, "In states that do not recognize
tenancies by the entireties, it may be possible to obtain similar
protection through husband and wife A-B living trusts (or by a division
of assets) ... where a couple in a stable marriage wish to divide their
property equally to avoid claims against one spouse who is in a risky
profession. ... Each spouse sets up a living trust providing a lifetime
income to him or herself, with the remainder to the children. The
exempt property is put in the trust of the at-risk spouse and the non
exempt property is put in the other spouse's trust." (From the
Professional Asset Protection Manual by Mark Warda.)
This strategy should provide better asset protection than
simply owning the home as joint tenants with rights of survivorship,
which is the most common approach. This is an approach for those who
have a problem with giving their home to their children as explained
next.
Qualified Personal Residence Trust
A much stronger form of protection is available with the use of a
"Qualified Personal Residence Trust" or QPRT.
This device is best suited to situations when there is a substantial
estate tax problem and when the home (or a vacation home) has a
substantial value. However, it seems to me it could also be used as a
pure asset protection device for family real estate even when estate
taxes are not a significant concern.
In a nutshell, the QPRT involves making a future gift of your
residence (or a vacation home) to your children at the end of a term of
years selected by you. The house is put into a grantor trust to hold
the property until the term of the trust has expired. Until the end of
the term of years, you continue to use the home. At the end of the term
of years (selected by you), the home belongs to the beneficiaries of
the trust - usually your children.
By making a delayed gift, the value of the gift is discounted
at an interest rate prescribed by the IRS, based on the term of years
that you select. The longer the term of years, the lower the current
value of the property for gift tax purposes.
If you die before the end of the term of years for the QPRT,
the home is included in your estate and you've gained nothing in terms
of estate taxes. But - your home has been protected from creditors
while the trust was in existence. Thus, a QPRT could be worthwhile
purely as an asset protection device.
After the term of years of the QPRT, the home is transferred
to your children. Until recently, you could arrange to buy it back from
them if you made the purchase before the end of the term of the trust.
However, the IRS has recently ruled that type of repurchase arrangement
will invalidate the trust ,
or you can arrange to pay them rent or you can find another
place to live. Perhaps you could set the term of years to coincide with
the time that you plan to move to Florida or southern Texas.
Family Limited Partnerships
There seem to be some advisors who advocate putting a residence into a family limited partnership for asset protection.
In their book, Lawsuit Proof, Robert Mintz and James Rubens
state that "After setting up the FLP, all family assets are transferred
into it, including the family home, ...". (Emphasis added.)
I've heard similar comments from speakers on the topic. Some advisors
advocate putting the home into a separate FLP, while others (with whom
I agree) feel the FLP isn't appropriate for a residence, if tax
benefits are of any concern.
I see a number of tax problems with putting a residence
into a FLP. The legal purpose of a partnership is to operate a
trade or business. The law generally regards the management of
investments as a business for this purpose. If a home is included in a
FLP that owns many other investment assets and if the FLP is owned in
part by family members other than a husband and wife, then I can't find
any justification for treating the home as a residence for tax
purposes. Any real estate taxes or interest on a home loan would be
allocated to all of the partners and would be treated as investment
expenses. If the expenses exceed the income, the losses would not be
allowed as a deduction until the partnership generates other income to
offset the losses.
If a partner is using a substantial asset of the partnership
without compensation to the partnership, the legal validity of the
partnership is highly questionable. So, if you put your home into a
FLP, do you want to pay rent to the FLP and lose the tax benefits of a
tax free rollover and the $125,000 tax free gain on selling a home
after age 55? Some advisors argue that if the FLP is owned entirely by
a husband and wife, the tax benefits will be retained, just as when a
home is put into a revocable living (grantor)
trust. But that's an arguable and untested theory. Do you want to
be the legal guinea pig to test the theory? (I wouldn't.)
If (1) the FLP is owned entirely by the husband and wife, if
(2) the partnership has no other assets and if (3) they don't pay rent
for the use of the home, then I have a really hard time finding a good
reason why any court would allow this arrangement to prevent a creditor
from getting an attachment.
Maximum Debt
If none of the preceding strategies to protect your home equity are
appropriate for you, then you may need to consider taking out the
biggest loan you can get on your home. That will make the home totally
unattractive to a judgment creditor. As long as you are solvent and
don't make a fraudulent transfer, you can then put the cash into a
family limited partnership or an offshore asset protection trust.
Hopefully, you can invest the money you borrow to earn enough to pay
the interest on the mortgage.
Foreign Grantor Trust
The tax benefits of a residence are not lost when the home is
transferred to a grantor trust. In the U.S., a grantor trust
provides no asset protection. However, an offshore trust is usually
treated as a grantor trust for tax purposes, even though the trust
provides asset protection benefits by virtue of the more favorable laws
(to you) of the foreign jurisdiction. Thus, if you have a very valuable
home, and if the previous methods of protecting the equity won't work
for you, a last resort might be to put the home into a foreign grantor
trust. But - some states prohibit putting real estate into a foreign
trust and the land can't be moved to a foreign location so it's exposed
to U.S. courts.
Further details about protecting your assets from future
lawsuits are available in our subscriber's
web site. Changes in the tax laws and various federal and state
laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection
Strategies.
Further details about protecting your assets from future
lawsuits are available in our subscriber's
web site. Changes in the tax laws and various federal and state
laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection
Strategies.
NOTICE: This
Information is intended only for educational purposes and may be
regarded as controversial by some legal experts. Readers should consult
with a qualified professional who is familiar with their specific
financial and tax circumstances before adopting any ideas that are
discussed in this article.
About the author:
Vernon Jacobs is a CPA/CLU who works as a
tax author and consultant.
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