Equity Stripping Leaves Creditors Empty-Handed
Equity stripping, the process of reducing the equity value of a real estate asset, is one of the oldest asset protection strategies. It basically entails encumbering the property with debt to the extent that there is little or no equity for creditors to acquire. By giving another party a claim against the property, owners retain control over the cash flows and use of the asset, while making the property unattractive to those trying to perfect any type of legal judgment. Although a seemingly straightforward approach, there are certain requirements that must be met in order to ensure its effectiveness and various ways to execute this strategy that provide increasing levels of benefit to owners.
Basics of Equity Stripping
Not to be confused with the foreclosure remedy scam, equity or collateralization stripping is conducted to safeguard the ownership of real estate assets by making the equity in those assets valueless in the eyes of creditors. Although there are many different equity stripping strategies, they all entail controlling real estate assets without having large equity interests in them. By making the equity in the property difficult or costly to obtain, owners hope to insulate their homes and other property from attachment in legal proceedings. The idea is simple: keep control and enjoyment of a property but leave little or no equity for a creditor to get. (For more, read Avoiding Foreclosure Scams.)
However, as with any type of asset protection strategy, equity stripping must be executed well in advance of the need for protection. Executing any asset projection strategy during a legal procedure will usually be considered improper by the courts. For example trying to put assets into someone else's name would be considered a fraudulent transfer done for the sole purposes of hiding assets.
Traditionally, the most common form of equity stripping (known as spousal stripping) was to quitclaim the title to a spouse who was less likely to be sued for financial reasons. This previously effective strategy is no longer used, since divorce is now a greater threat to assets than legal liability.
Now, the most common way to reduce the probability of attachment is by borrowing against the asset and giving another party a lien for the debt obligation. The most common form of borrowing is the home equity line of credit (HELOC). With a HELOC, the lender is given a lien against the equity of the property, which serves as collateral for the loan. Even an unfunded equity loan will significantly reduce one's equity "on the books" without creating any significant risk for the borrower. Most equity lines of credit do not charge a fee for not using the funds, and are very cheap (if not free) to set up. HELOCs make it much more difficult and costly for a creditor to get at the actual equity in a property and will often deter creditors from initiating legal proceedings, without affecting the cash flow of the borrower.
Placing an unfunded HELOC on a property is the first line of defense for any property, which also provides a source of funds that can be used for emergencies or other unexpected financial obligations. If it remains unfunded, the HELOC will not add any financial risk in the form of required interest and principal repayments. Since creditors cannot tell how much is actually owed to the bank, this strategy can be effective in discouraging a party from going after the property, but is less effective if the creditor does decide to go to court.
A more effective, albeit riskier, means of protection is to use funded loans in the form of a HELOC or second mortgage. When the loan is funded, the lender receives a "priority lien," a claim against the equity for the amount borrowed that supersedes the judgment of any creditor. In this case, the equity in the property is actually reduced by the amount of the capital borrowed, which cannot be recovered through legal means, further reducing a creditor's motivation to sue.
Many states have homestead exemptions which limits the amount of a home's equity that a creditor can seize to satisfy a financial obligation. But for most people, the homestead exemption will only protect a fraction of a home's equity value. For example, a $400,000 home with no mortgage and a $100,000 home exemption would have $300,000 of equity exposed to potential legal claims. In this situation it would make sense to keep some type of loan on the property so that the equity is never more than $100,000. In this case, if something happens and a judgment is entered, a creditor would look at the property records, appraise the value of the house, and decide that it there is little to be gained by expensive legal action.
However, the issue with funding the loan is twofold. One, the property owner must find a use for the capital that will be more or equally productive as the investment in real property. Secondly, the owner must be able to maintain the loan by making the requisite monthly principal and interest payments or risk foreclosure by the lender. There are many accounts of property owners stripping their properties for capital and investing it in the stock market. This strategy was celebrated in bull markets but also helped fuel foreclosure rates in extended periods of market decline. When considering this strategy, most people fail to think of how to properly use or invest the proceeds they have pulled out of their properties. (For a background reading, check out our Investopedia Special Feature: Subprime Mortgages.)
To reduce the risk of foreclosure, some owners obtain a "friendly loan" from a business or trust controlled by someone that they know personally. Because of the personal relationship, owners assume that the lender will not foreclose due to a period of slow or non-existent loan payments. As ineffective strategies, many of these friendly loans are eventually dismissed as fraudulent because they do not appear to be genuine.
Although every jurisdiction has its own specific regulations, to pass muster the loan must be made for a specific economic purpose, must be properly documented and the mortgage lien filed. More importantly, the principal and interest payments must be made on time and in accordance with the loan documents. Many loans placed for the protection of property are dismissed by the courts because the borrower never made or documented making the mortgage payments.
Cross-collateralization is another asset protection strategy that encumbers the equity in a property, because it is used as collateral for multiple other assets. Even though it may not have an outstanding lien on it, it cannot be attached because it stands to protect the interest of another loan or guarantee.
For the most part it works this way: Assume that two companies owned by the same group have property. Company #1 makes a loan to Company #2 and uses its property as collateral. Company #2 then uses the loan proceeds to give Company #1 an equivalent loan and pledges its property as collateral. Without any money going outside the same ownership group, both properties have property liens and are now protected from creditors. If Company #1 is sued and a judgment is obtained against the property, it can still be used without issue. Eventually, when it is sold, the proceeds are used to pay off the existing mortgage loan, leaving the creditor with no recourse against the property. Although this is a very simplistic and transparent example, more complex structures using offshore entities and private trusts are often used that make it difficult for creditors to determine true ownership or prove that the transactions are not arms length.
Real Estate LLCs
Owning rental real estate is a high-risk endeavor. It is very difficult to protect the asset from the legal liability of owning and managing the property. However, through the use of real estate LLCs, owners have found a method to protect their other assets from their real estate activities, and vice-versa. By owning property within a single-asset LLC, only the property itself can be sued, which insulates the owners other assets from attachment.
Since an LLC is a legal entity, creditors wishing to sue the owner can only pursue the owner's interest in the LLC. In order to insulate the assets further, the single asset LLCs are often owned by a managed LLC holding company, registered in a state like Nevada that only allows a charging order as the sole remedy for attacking the entity. Since the charging order only allows creditors to step in as a member, they will never receive any income distributions from the manager but incur tax liabilities, which are untenable, financially. Interestingly enough, most LLC strategies also suggest stripping the equity by use of the HELOC and using the funds to invest in or update other real estate property.
Equity stripping can be a very powerful asset protection tool, when done as part of a thought-out and well-crafted plan. It is often best used with other protection strategies, like the real estate LLC structure which protects the property and owner alike. These strategies must consider the strategic use of loan proceeds and be executed well in advance of their need in order to avoid being considered fraudulent transfers by the courts. As with any asset protection strategy, an attorney with knowledge in this area should be consulted before any loans or legal documents are executed. (To learn more, see our Mortgage Basics Tutorial.)