Drawbacks to Equity Stripping

Although equity stripping is arguably the most effective (and sometimes only) means of protecting a hard asset against hostile creditors, it is not without its drawbacks. The largest drawbacks to equity stripping involve the cost and effort in setting up a truly effective program that will completely encumber the asset for many years. To illustrate the point, let’s look at the drawbacks of taking out a 2nd mortgage to equity strip a home. In this example, the home has a fair market value of $500,000 and an existing mortgage of $200,000. The problem with taking out a 2nd mortgage to equity strip is threefold.

First, commercial lenders usually only loan up to about 80% of a property’s value1, leaving 20% of the equity exposed. Securing additional loans to completely encumber the property usually involve very high interest rates (typically 15% or so.) Second, as the loan gets paid down, the property becomes less and less encumbered and therefore more equity becomes vulnerable. Third, the cost of making interest payments on the loan can be quite expensive. For example, say you take out a $200,000 2nd mortgage on the above property, to equity strip it to 80% of its value. If this was a 30 year loan repaid in monthly installments at 7% interest, you would pay $195,190.00 in interest before the loan was paid off. If you take out another loan to for $100,000 in order to strip the property of all equity, you may pay 15% interest. Under the same repayment terms as before, the interest payments equal an additional $355,198.40. Inflation notwithstanding, this is a very expensive means of asset protection! Of course you could invest the loan proceeds in government bonds, annuities or life insurance, but you will still likely end up paying more than you would earn with these investments. Riskier investments (such as stocks) could provide a greater return, but you could also lose money and end up worse off than if you hadn’t invested the proceeds at all.

Although alternative equity stripping methods exist, which may more fully encumber the asset, loan interest payments often remain discouragingly costly. One obvious way to eliminate commercial loan costs is to privately fund a friendly entity and then loan the money back to the original funder as a means of stripping the target asset’s equity; however few individuals have sufficient liquid assets to fund a loan large enough to completely strip the property.

Because of these and other concerns, the author developed a method called “Equity Stripping via LLC Capital Contributions”, or ESLCC2, yet even this program has its shortcomings. For the sake of orientation, let’s summarize the pros and cons of ESLCC.

The pros are:

• The loan is repaid by rendering management services to an LLC, instead of making cash payments to  3rd party. Managing your own entity, which  invests your and another person’s money, is far preferable to making cash payments you’ll never see again.

• The target property can be encumbered up to 125% of its value, and unlike conventional mortgages this lien will not diminish before the loan’s maturity date. Furthermore, the lien can grow at 8-11% per year, to cover market appreciation and equity that becomes exposed as a mortgage is paid off.

• Unlike “friendly liens” that are filed by a friendly entity without consideration, the ESLCC’s lien is placed on property in exchange for an instrument of equivalent value that is not attachable by (and has little worth to) creditors.

• Equity stripping is a little-known strategy and is thus unlikely to be challenged. ESLCC is even less well-known than other equity stripping programs, which works further to our advantage.

The cons are:

• If the minimum cash contributions are made to the LLC (typically 2% of the amount to be equity stripped), the program, if challenged, may not pass a judge’s “smell test”, especially if the equity stripping was done after creditor threat had already arisen. The ratio of cash being managed by the LLC manager, as opposed the claimed value of the management services, is simply too skewed.

• Although there is a good cover story for the purpose of the lien, the lien is nonetheless held by an entity that is an insider of the debtor under fraudulent transfer law. Despite the fact that ESLCC is overall a moderately strong equity stripping program, and much less costly to implement and maintain than other programs, there remains room for improvement. These improvements are found in multi-stage equity stripping.

Multi-Stage Equity Stripping

The benefit of equity stripping property with commercial loans is that it’s almost impossible to prove such a loan to be a fraudulent transfer. In other words, the property is out of a creditor’s reach to the extent it’s encumbered by a commercial loan. Multi-stage equity stripping involves a combination of ESLCC and commercial or equivalent private lender equity stripping to provide a solid combination of the benefits of both methods, while minimizing the drawbacks of each. Using the same target property we described earlier, figure 1 illustrates how such a program might be implemented:

As you can see, multi-stage equity stripping is complex, so let’s go over each part of Figure 1 in detail.

• A home equity line of credit for $200,000 is obtained from a commercial or private lender. Although the line of credit should be obtained long before creditor threat arises, one need not use the line of credit until a threat appears. This means that you will not have to make any interest payments until you need to borrow cash in order to activate the lien against your home.

• Once a threat appears, the line of credit should be exercised completely, and the proceeds invested in an exempt asset, such as a membership interest in an LLC. The LLC could then use the proceeds to purchase another exempt asset, such as an annuity or life insurance policy (be sure to check and see whether life insurance and/or annuities are protected in your state. If they aren’t, then consider an Isle of Mann annuity or life insurance product. Remember that state exemptions do not protect against IRS claims!)

• Borrowing against the line of credit and then transferring the money to a protected position may be looked upon as a fraudulent transfer, if it’s done after a creditor threat materializes. We can greatly reduce this risk by forming an LLC while creditor seas are calm, and funding it with a promissory note (this LLC should also have a 2nd member who would not be considered an insider under the U.F.T.A.3) When the money is taken from the line of credit, you simply pay off the promissory note – a pre-existing debt – that you gave to the LLC. This will minimize the chance of a fraudulent transfer claim, since a hostile creditor whose claim has not yet been reduced to judgment will not likely be given precedence over an already existing creditor.

  • When the LLC purchases a life insurance policy for its member (you), you can borrow against the cash value of the policy to help make interest payments on the line of credit, if needed, until the creditor threat passes.

• By using the line of credit to strip your property of 80% of its equity, we can use the ESLCC program to further encumber the property to 125%. The beauty of the ESLCC program is it allows you to encumber the last portion of your property’s equity in a relatively inexpensive manner, whereas to do so commercially would be very costly. Ironically, the last 20% of the equity in a property is least desirable to a creditor, and so the ESLCC program will probably not be worthwhile for them to challenge. The reason for this is that, if the creditor foreclosed on the property, they would almost certainly sell the property for considerably less than its actual fair market value (usually about 50-80% of the FMV.) In other words, the ESLCC program, when implemented in multi-stage equity stripping, does not cover equity that a creditor could likely convert to cash anyway upon foreclosure. Of course this leads us to ask the question: why then would we even want to cover the last 20% of a property’s equity with an ESLCC program? The reasons are as follows:

  • If at some point in the future you decide sell your home (not a forced sale), you will probably sell it for 100% of its value. The ESLCC program prevents a creditor from claiming a “piece of the pie” from your sale.

  • The ESLCC program involves a lien that appreciates annually. This means that as your mortgage and other liens are paid down, the ESLCC picks up the slack to make sure your property continues to be adequately encumbered.

• The ESLCC program can be made stronger by funding it with a promissory note to contribute cash as well as a promissory note to provide management services. Periodic interest-only payments on at least an annual basis will establish the note’s validity. Thus, the promise to manage the LLC would be worth a smaller percentage of LLC membership interest, and the program will appear more proportional and likely to pass a judge’s “smell test” if the arrangement is challenged in court. Although multi-stage equity stripping is more complex, high net-worth individuals and anyone else who might find themselves on the wrong end of a highly skilled and determined litigation/collections legal team would be well-advised to implement a reinforced program such as this.

Footnotes

1 Occasionally a commercial lender is willing to offer a home equity line of credit up to 125% of the property’s value; however these loans are often difficult to qualify for unless the applicant has an extremely high credit score. The interest payment costs remain problematic.