Innovative techniques for protecting your home

Along with retirement accounts, the family home is often the most valuable asset of the affluent. Beyond its financial value, the home has great psychological and emotional value. In fact, we find that most of our clients who engage in asset-protection planning often begin with the question: “How can I protect my home?” That is why we thought it important to discuss this asset and how to protect it from outside threats.

This article will look at the pros and cons of state homestead laws, tenancy by the entirety (TBE), limited liability companies (LLCs), limited family partnerships (FLPs), and the debt shield. You may be surprised to find out that a situation you have always feared could actually be your ally in your quest to protect your most valuable asset. This will be another example of a secret of the affluent that completely contradicts conventional ideas held by many average Americans.

State homestead law

Every U.S. state has some type of homestead protection law. In most states, such as New Jersey, New York and California, the level of protection is very low when compared with what real estate is worth (New Jersey: $0, New York: $100,000, California: $50 to $100,000). On average, state homestead law protection ranges between about $30,000 and $50,000 of equity - much less than the typical home value of the affluent.

Next: The option of joint ownership

Tenancy by the entirety

Tenancy by the entirety (TBE), a form of joint ownership available in a number of states, is a decent option for clients of those states, such as Alaska, Arkansas, Delaware, Florida, Hawaii, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, Wyoming, and the District of Columbia. In these states, the TBE homestead protection falls between +1 and +3, depending on the state and its court interpretations.

Inherent in TBE are a number of risks, including the following:

• Joint risk. Tenancy by the entirety provides no shield whatsoever against joint risks. Those are lawsuits that arise from your jointly owned real estate and even, potentially, car accidents.

• Divorce risk. If you rely on TBE for protection and you get divorced before or during the lawsuit, you lose all protections from TBE.

• Liability risk. If you rely on TBE for protection and one spouse dies before or during the lawsuit, you lose all protections from TBE.

• Death risk. Tenancy by the entirety is a poor ownership form for estate-planning purposes because, at the death of the first spouse, the entire value of the home will automatically be entered into the surviving spouse’s taxable estate.

For these reasons, we do not generally recommend TBE alone as a protective tool. The savvy affluent generally combine TBE with the debt shield technique.

LLCs and FLPs

Limited liability companies and limited family partnerships are two tools that can protect a primary residence. In fact, many advisers regularly recommend these techniques to their clients for this very purpose. The drawbacks of these methods are perfect examples of why multidisciplinary planning is necessary for the affluent. Let’s look at some of the problems with conducting asset-protection planning in a vacuum with respect to the home.

Drawbacks of LLCs and FLPs for protection of home

Owning real estate in an FLP or LLC can be attractive. However, when it comes to the primary residence, these entities are not very common or sensible choices of the savvy affluent.

Unlike other assets, the family home has unique tax attributes - most notably, the deductibility of mortgage interest and the $250,000 per-person ($500,000 per couple) capital-gains tax exemption. By owning the home within an LLC or a FLP, both of these tax benefits may be lost, unless only one spouse owns 100 percent of the interests in the LLC or FLP. In a recent case, however, the court set aside the protections of an LLC when only the debtor owned 100 percent of the interests in the LLC. For these reasons, we no longer recommend single-owner LLCs and FLPs to protect the family home.

Qualified personal residence trusts

When using a qualified personal residence trust (QPRT), the owner transfers ownership of the home to the QPRT irrevocably. While this is certainly 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 (typically 10 years), you have to pay fair-market value rent to the trust in order to live in the home.

Homes with mortgages on them present further tax difficulties, as well. For these reasons, while the QPRT is a strong asset-protection tool, we typically do not advise using it for most younger clients whose main concern is asset protection as opposed to estate planning. Nonetheless, if it can be implemented correctly, a QPRT receives a rating of +4 or +5 protection.

The unlikely solution most advisers can’t even mention

Oddly enough, the best way to protect a home is probably the same way we all started owning our homes - with someone else’s money. By not having any, or very little, equity in your home, the bank owns the home. A creditor has very little to gain from trying to attack the home when there is little to no equity - especially when that small amount of equity is partially or completely protected through homestead exemptions in many states.

Because we can’t go back in time and stop paying down our mortgages, we have to find a way to address this issue in the present. Unfortunately, most advisers can’t even tell you how to do this. Affluent Americans have to decipher financial information that is directed toward average Americans.

Consider this example: Individuals and firms in the securities and insurance industries have been the subject of a number of a rising number of complaints and lawsuits over the past 15 years. As a result, the regulatory agencies and compliance departments of these companies have forbidden their representatives from recommending that their clients remove equity from real estate and invest it into either securities or insurance products. These advisers cannot even accept loan proceeds from a refinanced property. These companies adopted this policy because they feared that less financially sophisticated homeowners wouldn’t understand the risk of this maneuver and might lose their homes if the investments they made with the loan proceeds didn’t perform well.

We approve of protecting less sophisticated investors and of protection against unscrupulous salespeople (and there are many of both). However, to threaten to terminate advisers who want to help affluent clients whose asset-protection concerns outweigh the investment risks that they and their teams understand is ridiculous. In this situation, the affluent can’t even get the advice they require. Let’s discuss that technique that most advisers can’t share but the savvy affluent know and implement on a regular basis: the debt shield.

Next: The debt shield

The debt shield

The debt shield can be the most effective way to shield the equity of the home. Essentially, using a debt shield means getting a loan against most of the equity in your home. For many clients, this is counterintuitive; they want to pay down the mortgage as much as possible. While this may have an emotional appeal, for asset-protection purposes, it is simply bad strategy.

For example, to help people protect the equity in their home, one financial institution we examined for a client designed an interesting debt-shield program. The bank loaned the client funds equal to up to 90 percent of the value of the home and then filed a mortgage - first, second or even third - in order to consume any remaining equity. The home was then protected.

The loan funds were placed in an asset-protected trust, one drafted for the client by an asset-protection attorney. Those funds were owned by the trust and, under the loan documents, were required to be placed in the bank’s certificate of deposit (CD) account. Further, the bank contractually guaranteed that its loan rate would be only 1 percent greater than its CD rate, meaning that this structure cost participants just 1 percent of the home equity to implement (plus legal fees). When the client retires or feels that the threat to the home has diminished, the CD account pays off the loan and the mortgage is released.

The enhanced debt shield

In the basic debt shield scheme outlined above, there is a real cost to the loan versus the investment - a shortfall of 1 percent per year. What if the funds you gain by shielding your home could be invested in a way that provided an opportunity to earn more within the investment than the loan interest would cost? In this way, you would make money by shielding the home through the concept of leverage. This is easily achievable in many states.

In some states, certain investment classes are asset-protected under state law. The most common such assets are annuities and cash-value life insurance policies, which are protected in many states such as New York, Florida, Texas and Ohio, among many others. In states such as these, you may take a loan for 6 to 8 percent (partially or totally tax-deductible) and be able to invest in an annuity or insurance policy that credits 5 to 8 percent or more (tax-deferred). When you consider that the mortgage interest may be tax deductible, the true after-tax cost to you may be as little as 3.5 to 5 percent.

If your asset-protected investment returns approximately 6 percent (many life insurance policies have guaranteed minimum crediting rates of 3 or 4 percent) and you are paying only 4 or 5 percent (after taxes) in interest, you can actually make money while protecting your home. Of course, this gain is not guaranteed and you could lose money in this arrangement. The savvy affluent understand these risks and act appropriately.

Consider this

For most affluent clients, there is no more financially valuable and psychologically and emotionally important asset than the family home. Some states offer great homestead protection, but most states offer inadequate protection. If you do not enjoy unlimited homestead protection, you must make it a priority to work with your team to protect your home. If you don’t protect this property, there is no need to bother protecting any other assets. The only thing more valuable than your home is your future income.

Michael S. Berry, Ch.F.C., is a financial planner in Newtown, Connecticut. He was named one of the “150 Best Financial Advisors for Physicians in 2013” by Medical Economics. You can reach him at 855-325-8674 or MBerry@daktori.com. He is a co-author with Mr. Jarvis of “The Physician’s Money Manual.”

Christopher R. Jarvis, M.B.A., C.F.P., president and co-founder of Daktori, has more than 20 years of financial consulting experience and has written 12 books including “Wealth Secrets of the Affluent” and “The Physician’s Money Manual.” He too was recognized as one of the “150 Best Financial Advisors for Physicians in 2013” by Medical Economics. You can reach him at 855-325-8674 or jarvis@daktori.com.