Can u Keep it?
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  Equity Separation

As discussed in the homestead section, it is no longer possible for people to ‘shelter’ some equity from creditors. As a result, many wealth holders opt to shift their equity from non-protected assets and instead place this equity in a protected vehicle. The process of creating encumbrances on a property to protect it from creditors is known as “equity stripping” or “equity separation.”


These liens on the property come in many forms. Stripping a home of equity by placing a traditional mortgage on a house allows a homeowner to enjoy the use of the property while protecting it from creditors.


Case Study

Assume Alan Whitmore lives in a state with a homestead exemption limited to $50,000. At the last appraisal, his primary residence was valued at $1,000,000. If his home were paid in full, he would have a “sitting duck” asset of $950,000.


Instead, Alan takes a maximum loan on the property, negotiating a loan for 90 percent of the value of the home at a 6 percent interest rate. Now, in addition to the $50,000 protected by the homestead exemption, $900,000 is protected, meaning only $50,000 is at risk from Alan’s home.


This is a significant advantage to Alan and a disadvantage to his creditors. In the event of a possible collection, the collector would pull property records and deeds before learning that the creditor is in a secondary position to the bank, who will receive $900,000 of the $1,000,000 worth. $50,000 is protected via homestead exemptions, leaving only $50,000 for the creditor. The collector would know that after the cost of the foreclosure proceedings, attorneys, fees, and sales costs, the collector would likely get nothing.


Equity stripping may seem like the holy grail of asset protection, but there are problems. If a wealth holder strips equity, he still must make payments to the mortgage company, which can be a problem if a creditor has frozen assets. If the wealth holder does not have money set aside to support mortgage payments, the homeowner mind find his home being foreclosed.


We can solve the problem using the building blocks of asset protection—namely, business structures and trusts.


Case Study

Assume the same facts as before: Alan’s home is worth $1,000,000. Because the home is paid in full and the state recognizes only a $50,000 homestead exemption, $950,000 of its equity is exposed. Alan takes a maximum loan on the property, negotiating a loan for 90 percent of the value of the home at a 6 percent interest rate, as well as a minimal prepayment penalty.


Alan deposits the $900,000 check from the bank into his wealth protection limited partnership, letting the money season in the limited partnership.


After the prepayment penalty expires, the limited partnership assumes the first trust deed on the property. The limited partnership opens escrow, deposits $900,000 into the account, and at the closing of the loan, assumes the $900,000 first trust deed.


Alan now makes the monthly mortgage payment to the wealth protection limited partnership, which he controls. Although he never anticipates a change in his financial condition, now he can sleep easier knowing he will not lose his home if he is late paying this mortgage to his own wealth protection limited partnership. 


That might seem easy to do, but remember that you must adhere to all of the strict formalities of a conventional loan. Not only does the loan need to look, act, and smell like a conventional loan, all of the formalities with the limited partnership must be adhered to as well. If the limited partnership appears to be your own personal piggy bank, the loan (and likely all of the money in the limited partnership) will be available for creditors.


Let’s see how this situation affects a person’s taxes. In most cases, it is impossible to deduct interest on a primary home. However, most people (as well as advisors and CPAs) do not understand how to properly compute the allowable mortgage interest deduction. While teaching a recent continuing education seminar for a national accounting association, I asked CPAs the following question:


Assume John bought his home in 2000 for $500,000, put down 20 percent, and mortgaged the remaining $400,000. Assume he paid off $50,000 in principal and the home appreciated to $1,100,000 by 2007. John decided to strip the equity and increased his mortgage to $1,000,000. What is the maximum amount of interest he can write off?


Of the thirty CPAs in the room, not one answered the question correctly. Most answered $1,000,000. There were a few at $500,000 and a smattering of other amounts. The correct answer is $450,000, which includes $100,000 over the lowest indebtedness the property ever had, which was $350,000 before he took out the $1,000,000 mortgage.


My point is this: Most wealth holders enter into complex wealth protection plans, and they must address all issues with qualified advisors to see what amount, if any, is deductible from taxes. By choosing accountants who subscribe to the Contrarian Wealth Management and Risk Protection Philosophy, you can find advisors who use legitimate and creative strategies—to avoid problems.


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