Along with retirement and personal investment accounts, the family home (and its equity) is often our most valuable asset. Moreover, with the white-hot 2021 real estate market, most homeowners have seen the value of their homes increase significantly, potentially putting even more equity in a liability-vulnerable position.
Beyond its purely financial value, the family home has great psychological value as well. In fact, we find that most of our clients who engage in asset protection planning begin with the question, “How can I protect my home?”
“Inside Risks” – Use Insurance
“Inside risks” are those which threaten the home because of potential liability created by the home itself. This would encompass injuries on the property, such as slip/falls, pool accidents, and even liability for guests drinking at the home and then driving (including guests of teenage or college-age children). While these risks are quite rare, they can be significant in terms of potential liability.
The best way to shield the home (and other assets) from inside risks is to use insurance – specifically, homeowners and umbrella coverages. Homeowners insurance will often be required by lenders if one has a mortgage on the property but required coverage amounts are a floor and may not be adequate for sufficient protection. Umbrella coverage should also be considered essential, even if not required by lenders. Given its low cost (millions of dollars of coverage can often be obtained for less than $1,000 annually), umbrella coverage is an efficient asset protector. One should be sure that the terms of the umbrella policy “fit” with the homeowners and auto policies, so there is no gap in coverage.
“Outside Risks” – Use state exemptions, co-ownership and legal tools
“Outside risks” to the home are potential claims against the homeowner (or spouse) for any reason. These types of risks include potential claims for medical or professional malpractice, auto accidents and contractual liability or claims arising from personal guarantees. There are several tools to shield the home and its equity from such potential claims:
- State Homestead Law
As discussed in previous columns, every state has some type of homestead protection law which says that some amount of home equity is “exempt” from lawsuits and creditor claims. In a few states, homestead laws protect an unlimited value, although there may be some geographic limitations (Texas and Florida are examples). In those states, homeowners need only to confirm that their homes qualify, and their home equity is fully protected.In most states, however, including Illinois, New York, and California, the value that homestead rules protect is very low when compared to what real estate is worth. On average, state homestead laws protect about $30,000–$50,000 of equity — much less than the value of many of today’s homes. In those states, additional protection options must be examined.
- Tenancy by the Entirety
Often described as a “quasi-exempt” asset class, tenancy by the entirety (TBE) is a form of joint ownership for married couples that is available in several states. In essence, in the states that protect real estate well through TBE, the home will not be subject to any claims against one spouse. This can be very valuable to a married couple when one spouse has significant exposure (i.e., physician) and the other does not. Inherent in TBE, however, are some limitations, including providing no protection for joint risks or for unmarried people.
There are many types of trusts that can be extremely valuable in asset protection planning. When shielding a home, the two most popular are a domestic asset protection trust (DAPT) in states that allow them and a qualified personal residence trust (QPRT) in all states.
About 20 states, including Ohio, Connecticut, and Nevada, have adopted DAPT legislation. In these states, one can set up an irrevocable trust and be a beneficiary of the trust. When there is no lawsuit concern, the homeowner can access the trust assets as the beneficiary but if they have lawsuit claimants pursuing them, the trust can be written so that the trustee cannot make distributions to you as you are “under duress.” Because there are no distributions, a DAPT can protect the home extremely well.
Homeowners in all states could use a QPRT to protect their homes. While this is effective for both asset protection and estate planning purposes, it comes with a significant cost—you no longer own your home. In fact, when the term of years is up (the typical range for a QPRT is five to twenty years), you must pay rent to the trust just to live in the home. Also, homes with mortgages on them present tax difficulties.
For these reasons, homeowners should use experienced legal advisors when implementing both DAPTs and QPRTs.
- Debt Shields
The debt shield can be an effective way to shield the equity of a home. Essentially, using a debt shield means getting a loan against the equity in the home. For many clients, this is counterintuitive, because they want to pay down the mortgage as much as possible. While doing so may have an emotional appeal, for asset protection purposes it is the exact opposite of what one wants to do in states where homestead, TBE and trusts are not viable options.
For some, using a debt shield does not mean taking a new loan on their home at all. Rather, it may mean not following a strategy of paying the mortgage down quicker than what is required. Here, the decision on whether (or to what extent) to pay down a mortgage they already have is examined from the asset protection perspective (could the funds be invested in another better-protected asset?) and the wealth accumulation perspective (could the funds be invested in another better-performing asset?). When getting a new loan is involved, the analysis is identical.
From an asset protection perspective, the transaction is simple—use the debt shield to move the equity from the vulnerable asset (the home) to a better-protected asset. From an economic perspective, the decision process is also simple—consider whether the cost of the equity move (the after-tax interest cost) is higher or lower than the return that the asset ultimately purchased with the loan proceeds can generate, along with the “safety” of the asset in which you are investing.
For most individuals and married couples, there is no more financially valuable and psychologically important asset than the family residence. Some states offer great homestead protection, but most provide an inadequate shield. Potential options include TBE, trusts, or some type of debt shield strategy.