Equity stripping is a set of financial strategies used to protect assets, such as real estate, from creditors. The goal of equity stripping is to reduce the equity in the property to the smallest possible, to make the property less appealing to potential claimants.
Home equity is the difference between your home’s market value and all outstanding liens against your property. Home equity changes in response to the real estate market and interest rate fluctuations.
Debtors use equity stripping to make their property appear as low in value as possible to their potential creditors. It is also used by predatory lenders when a homeowner is facing foreclosure.
Why do people use equity stripping as a financial strategy?
Suppose you want to protect your property assets from potential legal claims, lawsuits, or other financial difficulties. Using equity stripping, you would intentionally take out a mortgage on your home or investment property. By borrowing against the value of your home or business properties, you reduce the equity in these assets and, therefore, the equity available to creditors to claim.
Once you have a mortgage on your property, the creditor cannot place a lien on the property equity that the lender is entitled to as part of their security interest. As the owner, you have given a claim to your property to your lender while still retaining use of the property and maintaining your cash flow.
What is a lien?
A lien is a legal claim or encumbrance placed on a property or asset by a creditor as a result of a debt or obligation. For example, if you take out a home equity line of credit (HELOC) on your home with a plan to use it to fund a vacation or even to leave the money untouched, the bank will place a lien on your home as collateral for the loan.
If you don’t pay back the loan, the bank can take your home as a repayment for the loan. As a lien holder, the bank is announcing to all future claimants that it already has a claim on your home, and any other creditors will need to wait their turn. Liens are enforced in chronological order as they are placed on a property. Junior lien holders, whose claims lie further down the line, may end up with nothing.
While equity stripping can protect the value of the HELOC, the rest of your home equity remains unprotected, and the HELOC will show up on your credit report, making it difficult to get additional loans.
Many states provide homestead exemptions that protect a portion of your personal home’s value. The percentage of your home’s value covered by the homestead exemption varies by state.
There are other ways to strip equity from your properties.
What are some equity stripping methods?
The goal of all equity stripping methods is to reduce the equity in a property. These methods must be used legally and without fraudulent intent. Attempts to use equity stripping to defraud creditors, such as transferring assets into another person’s name with knowledge of a potential claim, can result in legal consequences. Methods of equity stripping include:
- Mortgages and liens: Taking out a mortgage or borrowing against your home equity reduces the equity available to creditors. The borrowed money can then be used for legitimate business or personal purposes, and the loans are structured to make repayment financially comfortable. However, interest on the loan can make this an expensive form of asset protection.
- Asset transfer: Transferring ownership of assets to spouses or trusts can shield them from creditors. If you establish an irrevocable trust and transfer property ownership to the trust, you no longer own it, and it is no longer accessible to your creditor. If one spouse is at increased risk of a potential lawsuit, the real estate title can be transferred to the other spouse. Of course, divorce may be a higher threat than debtor claims, and communal property states make this strategy more difficult to implement.
- Encumbrances: Long-term leases or easements on the property can reduce its market value.
- Borrowing from a business or trust: Borrowing money from a protected entity you own, such as an LLC, or from a business or trust owned by someone you know personally allows you to have a lien placed on your property without fear of foreclosure. Each jurisdiction has its own regulations for these types of loans. Lenders must show the loans are made for specific economic purposes, are properly documented, and have filed a mortgage lien. Loan documents and records must outline the terms for principal and interest payments and document that they have been made.
- Using a protected entity: Since an LLC is a legal entity, creditors can only pursue the owner’s interest in the LLC. Other strategies include borrowing money from your LLC and having the protected entity place a loan on your property or having your single-asset LLCs owned by managed LLC holding companies registered in a state that allows a charging order as the only way to attack the entity.
Real estate investors use another form of equity stripping. The investor buys a property from a homeowner facing foreclosure and then leases the property back to the previous owner. The investor buys the property at a discounted price from a motivated seller and leases it to the previous owner, acquiring a paying tenant.
When conducted thoughtfully and legally, as part of a well-crafted asset protection plan, equity stripping can help protect your property from creditors or legal claims, give you more money to invest, allow you to continue to use your property, and make your property less attractive to creditors. These strategies must be executed well in advance of when you might need them. Otherwise, the courts may view them as fraudulent transfers.