Updated: Jan 31, 2019
The very wealthy are always looking to decrease the appeal of specific assets with regard to creditors and litigants. There are new strategies that may help create protective measures.
Two Steps to Equity Stripping
Once such asset protection strategy, known as equity stripping, can be very effective when it comes to shielding tangible assets, particularly real estate, from creditors. There are two principle actions that need to take place in order for this strategy to be effective.
The first step would be to create a legitimate debt to encumber the property. By doing so, this will reduce the value of the property, consequently making it far less attractive to any creditors. The property exposure will only be to the lender, but not to the unsecured creditors. In concert with this, the owner will have extracted cash from the property. The second step revolves around converting the cash into another asset that will be protected from creditors. The idea is to create an exempt asset that is beyond the creditors.
Step one entails creating a loan. The loan can either come from a commercial lender, such as a bank, or from a private lender, oftentimes a friend or an associate of the owner. The commercial lender is often superior for asset protection purposes. A lien from a commercial lender almost always supersedes any creditor claims. The drawback to the owner that uses a commercial lender is the inability to control the situation. As with all commercial loans, terms, conditions, and payment schedules are set; failing to abide by these terms and conditions can result in a foreclosure. Also, commercial loans only represent a percentage of the total value since it is very difficult to obtain a 100% loan without extremely high interest costs.
The other possibility is for the owner to reach out to a private lender, often a close friend. The lender itself will be a financial entity, typically controlled by the close friend. The entity will provide the loan to the owner, secured by a lien against the property. Since this is a private loan, the terms and conditions will have much more flexibility than a commercial lender. As an example, the lender may provide 100% of the property value without having to charge a greater interest rate. The lender’s justification is that the value of the property is expected to increase during the term of the loan. However, with this flexibility comes the potential for the transaction to be considered a fraudulent transfer. In order to avoid this, the entire transaction must be executed carefully and within the letter and spirit of the law.
One last approach would be to use a combination of both a commercial and private lender. The commercial lender will initially provide the loan, and subsequently the private lender purchases a promissory note. The commercial lender will continue to administer the loan, but the private lender can now provide the flexibility to the owner/borrower. However, through the entire transaction, the creditor only sees the commercial lender as opposed to the private lender; and thus, is less inclined to battle.
Once the loan is taken, the owner must now convert the property into cash, which is typically more attractive to creditors than the property itself. Therefore, it is now important to have the cash protected. In essence, the cash must disappear. One of the easiest ways is to spend it, but since the intent is to employ the equity strip as an asset protection vehicle, it is necessary to transform the cash into an exempt asset.
Each state has identified assets that can be exempted from creditors. In addition, the Federal Bankruptcy Act has also listed exempt assets. The key is to understand the nature of these exemptions in order to be fully protected. As an example, exemptions only apply to natural persons as opposed to corporate entities.
In many states, an exempt asset is the cash value of life insurance. By simply using the loan proceeds to purchase a life insurance policy, the owner can now shield that asset from creditors while at the same time the cash is continuing to grow.
Due to the Modified Endowment Contract rules, it is extremely important to understand what the limitations are with regard to life insurance. In many instances, a private placement variable life insurance policy may be very useful, not only from the aspect of providing asset protection but also in deferring income and potentially avoiding any future estate tax.
One method of avoiding estate taxes is to use a trust structure. The only issue here is figuring out how to get the money into the trust without triggering extensive gift taxes. Once the money is transferred to the trust, the owner/borrower is no longer in control of the cash, nor is the owner/borrower a beneficiary. Thus, the creditors have no access to the money.
A structured product is another method of transforming cash into an exempt asset. These are commonly customized derivative transactions in which the cash is converted into future payments. This often slows down the creditors once they understand the money will not be forthcoming for many years.
Overall, there are a variety of ways of transforming cash into exempt assets. Some are fairly simple, such as purchasing life insurance or annuities or even putting money into a qualified retirement plan. Others are more elaborate and sophisticated approaches involving trust structures and derivative transactions.
As you can see, equity stripping will afford the owner the ability to secure a loan against selected assets. The greatest appeal is to use real estate assets, since real estate cannot be moved to another location. However, through the equity strip, the creation of the cash allows for the movement into other exempt assets.
The encumbrance of the asset with legitimate debt will result in a reduction in the net value of the asset; in turn, the appeal of the asset to creditors is diminished.