3 ways to protect your hard-earned cash from creditors

You’ve worked your entire life to buy a home, fund your retirement account, and put cash in the bank. But what happens if you cause an accident that seriously hurts someone? What if you guaranteed a loan for a child’s business that ultimately failed?

These, and other, scenarios happen to people every day. When it does, those unlucky people face the very real risk of watching a lifetime of work evaporate in front of them. But there are steps that you can take to make it harder—much harder—on creditors.

One option is to sell the property to a friend using a sale-and-leaseback agreement. Under this arrangement, the debtor sells the property to a friend and the friend leases the property back to the debtor. But the friend doesn’t pay for the property. Instead, the friend signs a promissory note with payments equal to the lease payments and then a balloon payment at the very end.

This strategy works well because it is simple and because it converts a house (which is a desirable asset for a debt collector) into a promissory note (which is a less appetizing asset).

But you’ll want to be careful: The transfer price should be around the market value and you’ll need to pay appropriate taxes, including the CNMI’s real-estate transfer withholding tax.

Another option is equity stripping. This approach involves several methods all working toward the same goal—reducing a person’s ownership in an asset by larding it up with debt.

What is equity? To explain, let me give you an example. Imagine that a person has a house worth $200,000 and no mortgage. Their equity is $200,000. If, by contrast, the house had a $100,000 mortgage on it, then their equity would be $100,000 (the house’s value minus the debt still owed).

Equity is important because when a bank or some other creditor forecloses on a property, they are not actually foreclosing on the property; they are foreclosing on the equity in the property. Thus, the less equity in a property, the less likely a creditor will be to foreclose on it.

How can you strip the equity in your property? In two ways: a bank loan or a paper strip.

Getting a bank loan is great. It puts cash in your pocket and shrinks your equity.

But it has two drawbacks. For one, a bank will seldom give you a loan equal to your equity. If you are lucky, you will get around 80 percent. That leaves 20 percent of your equity for creditors to carve up. For another, getting a loan means having to pay it back with interest. That can get expensive. Normally people deal with that by investing the loan proceeds. Sometimes that investment goes up; sometimes it doesn’t.

That brings us to a paper strip. Here, the person will recruit a friend to act like a lender. The person and the friend will then sign a mortgage saying that the friend lent money equal to the full equity in the property and then record that mortgage with the Recorder’s Office. It’s basically a sham transaction, but unless someone investigates thoroughly, the mortgage will look legitimate and fool a creditor into thinking that there’s no equity in the property worth pursuing.

A third option is to create an irrevocable spendthrift trust. It can be an excellent vehicle for sheltering money by moving it away from someone with heavy debts or a high risk of being sued and toward someone with few debts and a low risk of being sued.

Take an example. Let’s say that a father owns $1 million in assets but expects to have problems with creditors in the near future. He could set up an irrevocable trust and then designate his children as the beneficiaries. The money would no longer be his, so when creditors came a-knocking, the money would be safely squirreled away with the children.

What are the key features of an irrevocable spendthrift trust?

To protect the grantor’s assets, the trust must be irrevocable, meaning that once the trust begins the grantor cannot change their mind and dissolve it. Irrevocability is important because only irrevocable trusts protect against creditors.

Why? Because the grantor no longer owns or controls the trust funds. In other words, the trust funds are no longer part of the grantor’s assets. And so, even if a creditor could get a judgment ordering the grantor to turn over the trust’s assets, the grantor cannot do so because they no longer own or control the assets.

To protect the beneficiary’s assets, the trust should usually have a spendthrift provision. This provision prevents beneficiaries from transferring their right to receive trust funds to anyone else until the beneficiary actually receives the money. This prohibition comes in handy when a beneficiary has a debt collector breathing down their neck. In that case, the trust can often delay paying the beneficiary anything into perpetuity. That threat can encourage a debt collector to take less than what they are owed in exchange for the trust speeding up payment.

A warning though: If the grantor is also the beneficiary, then a spendthrift provision usually won’t protect the grantor’s share of the trust income and principal. But there are ways address that, which we will discuss in a future article.

To learn more about protecting your assets, consider speaking with an attorney with asset-protection experience. But be careful: Most attorneys don’t have much experience in this area.

Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including JZ Group. His columns—focused mainly on real estate and small business—are published every other Tuesday. jsundell@jzgroupinc.com

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This column is for informational purposes only and is not intended to be taken as legal advice. For specific cases, consult a lawyer.