One of the earliest methods of asset protection is equity stripping, which involves lowering a real estate asset’s equity value. It basically involves burdening a property with debt to the point where there is little to no equity left for creditors to take. Owners maintain control over the asset’s cash flows and usage by granting a claim against it to another party, making the asset undesirable to parties seeking to enforce any kind of judgment. Despite the fact that this strategy seems simple, there are a few conditions that must be satisfied to make it work. The owners may gain from this method in varying degrees in a variety of ways.
Basics of Equity Stripping
Equitystripping, also known as collateralization, is a process used to protect the ownership of real estate assets by rendering the equity in such properties worthless in the eyes of creditors, not to be confused with the foreclosure remedy fraud. Ownership-stripping techniques come in a variety of forms, but they always involve managing real estate assets without having significant equity stakes in them. Owners want to protect their houses and other property from attachment in court procedures, therefore they make it difficult or expensive to access the equity in the property. The concept is straightforward: maintain ownership and use of a property but leaving little to no equity available to creditors. Read Avoiding Foreclosure Scams for additional information.
Equity stripping must be carried out long in advance of the time when protection is necessary, just as with any other asset-protection plan. The courts often see any asset-projection tactic used during a judicial proceeding as inappropriate. For instance, attempting to transfer assets into someone else’s name just to conceal assets would be seen as a fraudulent transfer.
Quitclaiming the title to a husband, who was less likely to be sued for financial reasons, was historically the most popular method of equity stripping (sometimes referred to as spousal stripping), which is now illegal. This once-useful tactic is no longer used since divorce now poses a larger risk to assets than legal responsibility.
These days, borrowing against an asset and granting a lien to another party for the debt obligation are the two most popular ways to lessen the likelihood of attachment. The home equity line of credit is the most popular kind of loan (HELOC).With a HELOC, the property equity that acts as security for the loan is assigned to the lender as a lien. Even an unpaid equity loan will result in a considerable decrease in one’s on-the-books equity without putting the borrower at undue danger. The majority of equity lines of credit are quite inexpensive to set up, if not completely free, and do not charge a fee for not being used. HELOCs may prevent creditors from pursuing legal action without having an impact on the borrower’s cash flow by making it far more difficult and expensive for them to get the real equity in a home.
The first line of protection for any property is to have an unpaid HELOC on it. It also offers a stream of money that may be utilized for emergencies or other unforeseen financial demands. The HELOC will not pose any financial risk in the form of necessary interest or principal repayments if it is left unfilled. This tactic may be helpful in deterring a party from pursuing the property but is less effective if the creditor decides to go to court since creditors cannot determine how much is truly due to the bank.
Pulling a Second Mortgage
Using financed loans in the form of a HELOC or second mortgage is a more efficient, though riskier, method of protection. A priority lien, or a claim against the equity for the amount borrowed, is given to the lender when the loan is financed. This lien takes precedence above any judgment from other creditors. Since the money borrowed in this instance cannot be repaid via legal channels, the equity in the property is actually decreased, which lessens a creditor’s incentive to file a lawsuit.
Using Homestead Exemptions
Homestead exemptions are legal restrictions on how much of a homeowner’s equity may be taken by a creditor in order to pay back a debt. For the majority of individuals, the homestead exemption will only save a portion of the equity worth of a property. For instance, $300,000 in equity would be vulnerable to future legal claims in a $400,000 property with no mortgage and a $100,000 home exemption. Maintaining a debt of some kind on the property in this scenario would make sense in order to ensure that the equity never exceeds $100,000. A creditor would examine the property records, estimate the worth of the home, and determine, should anything happen and a judgment be rendered, that there is nothing to be gained through costly legal action.
However, there are two problems with financing the loan. First, the owner of the property must put the money to use in a way that will be at least as fruitful as their investment in real estate. Second, the owner must be able to make the required monthly principle and interest payments in order to continue the loan; otherwise, the lender may foreclose. There are several stories of home owners selling up their residences to get money for the stock market. This tactic, which was lauded in bull markets, increased the number of foreclosures during protracted downturns in the market. Most individuals who explore this technique don’t consider how to effectively utilize or invest the money they have extracted from their homes. (See our Investopedia Special Feature: Subprime Mortgages for more background information.)
Friendly Loans Strategy
Some owners get a friendly loan from a company or trust run by someone they know to lessen the danger of foreclosure. Owners anticipate that the lender won’t foreclose in the event of a period of sluggish or nonexistent loan payments because of the personal connection. Since they don’t seem real, many of these friendly loans are ultimately discarded as fraud.
Despite the fact that each jurisdiction has its own unique rules, in order for a loan to be approved, it must be issued for a specified economic purpose, be legally recorded, and have a filed mortgage lien. More significantly, the loan agreements must be followed and principle and interest payments must be completed on time. Courts often reject loans filed to protect property because the borrower never paid or provided evidence of making mortgage payments.
Another asset protection technique called cross-collateralization involves using a property’s equity as collateral for a number of other assets. It may not have an active lien, but it is exempt from attachment since it defends the interest of a different loan or guarantee.
Assume that two businesses controlled by the same group hold real estate to see how it works. Company #1 lends money to Company #2 and pledges its assets as security. Using the loan proceeds, Company #2 then extends a similar loan to Company #1 while pledging its assets as security. Both properties are now secured against creditors by property liens, with no funds leaving the same ownership group. The property may be utilized without restriction even if Company #1 is sued and a judgment is rendered against it.
The mortgage debt is eventually paid off with the profits from the sale, giving the creditor no further rights with regard to the property. Although this is a fairly straightforward and simple example, more intricate arrangements that include private trusts and offshore organizations are often used to make it difficult for creditors to ascertain genuine ownership or demonstrate that the transactions are not legitimate.
Real Estate LLCs
Real estate investment carries a significant level of risk. Protecting the asset from the legal obligation of owning and operating the property is quite challenging. However, owners have discovered a way to safeguard their other assets from their real estate operations and vice versa via the usage of real estate LLCs. Owning property via a single-asset LLC protects the owners of additional assets from attachment since only the property itself may be sued.
Creditors may only go for the owner’s stake in the LLC since an LLC is a legitimate company. Single-asset LLCs are often controlled by a managed LLC holding company incorporated in a state like Nevada, which permits a charging order as the only method of assaulting the business, in order to further protect the assets. The charge order only permits creditors to participate as members, thus they will never receive revenue distributions from the management but will instead be responsible for tax responsibilities; this is financially unjustifiable. Surprisingly, the majority of LLC-based solutions also recommend removing the equity via a HELOC and utilizing the proceeds to acquire or improve additional real estate properties.
The Bottom Line
Equity stripping may be a highly effective asset-protection measure when used as part of a well-thought-out plan. It is sometimes utilized best in conjunction with other security measures, such as the real estate LLC structure, which protects both the owner and the property. In order to avoid being seen by the courts as fraudulent transfers, these tactics must take into account the strategic use of loan profits and be put into action well in advance of the need for them. A knowledgeable lawyer in this field should be contacted before signing any loans or legal contracts, just as with any asset-protection plan. (See our Mortgage Basics Tutorial for additional information.)
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