Three fundamental asset-protection strategies

Last time we discussed five reasons why you need asset protection in your life. Those reasons include what you’d expect like preventing lawsuits, reducing the cost of resolving them when they do happen, and generally increasing the chance you’ll keep your stuff when bad things happen. But they also extend to improving your financial plan and gaining greater peace of mind.

Now let’s talk about the three overarching strategies for doing just that. They are exemption planning, titling your assets in a protective entity, and equity stripping.

Let’s begin with exemption planning. This form of planning centers on owning as many assets as possible that enjoy some form of statutory protection from lawsuits and creditors. These assets are known as exempt assets. They normally include personal residences, personal effects like furniture and clothing; pensions and retirement funds such as IRAs, 401(K)s, and pensions; and life insurance.

But whether an asset is actually exempt varies from place to place. Florida, for instance, has a generous exemption for personal residences while the Commonwealth does not. This matters a lot if you own assets in more than one state or if you move from place to place.

Likewise, the strength of the exemption shifts with the situation. Take, for instance, an IRA. In a bankruptcy, an IRA will receive considerable protection—typically up to $1 million. But in a tax case, it won’t receive much protection at all.

Next up is titling assets into a protective entity. This strategy involves having your assets owned by a trust or company that is beyond the reach of your creditors. Sometimes that means parking money in a trust. Other times, it means moving assets into a limited liability company or a family limited partnership.

Consider a common example for wealthy folks. They often form a trust in a far-flung locale like the Cayman Islands and then appoint a person in that jurisdiction to manage the trust. Why? Because U.S. court’s have no authority over the Cayman Islands. So, even if a U.S. court orders the offshore trust to turn over money, the court has no power to force the offshore trust to comply.

But asset protection does not require going far from home. Another popular tool is a family limited partnership, which is actually no different from a limited partnership except that the partners are family members. The benefit of this structure is two-fold. First, it enables the family to move assets behind the LP’s asset shield and, second, it can reduce estates taxes for a variety of reasons beyond the scope of this article.

That brings us to our third strategy: Equity stripping. This approach involves encumbering the asset with liens to make it less attractive for creditors. The most common version of equity stripping happens by accident in most cases—a mortgage.

To see how it works, let’s look at an example. Say that you find a house worth $500,000. If you bought the house with cash, then you have $500,000 worth of equity in the house. And all of that equity is fair game for your creditors.

But what if you paid $100,000 in cash and used a loan for the remaining $400,000? Now your equity is $100,000 and your debt is $400,000. And your lender would stand first in line to take back the property if anything goes wrong. So, your other creditors would not have access to any of your equity until the lender was out of the picture.

The downside of debt-based equity stripping is that it is expensive to do legally. After all, bank loans don’t come cheap—at least in the Commonwealth. To get around this, some people will file a bogus lien on their property. In other words, they will find a friend and ask them to file a lien pretending to create a significant debt. But this is fraud and easy for creditors to attack if they get wind of the plan.

Fortunately, there are better ways to equity strip than loading up an asset with debt. A better way is to encumber the asset with an obligation. For example, you could start an LLC with two owners, have one owner contribute the startup costs in exchange for a small percentage of the ownership (usually between 1% and 5%), and have the other promise to contribute a much bigger sum over time in exchange for the balance of the ownership. The LLC can then use that promise to place a lien on the second owner’s property. That lien, in turn, would trump other creditors.

As you can see, the menu of asset-protection strategies is extensive. In fact, there are hundreds, if not thousands, of variations that mix and match these basic ingredients. If you’d like to sample any of the meals on that menu, talk to an asset-protection expert. This is not an area of law where you want to go it alone or partner with a generalist.

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