What is Equity Stripping for Asset Protection?
In most cases, the debtor obtains a loan from a commercial bank and secures the loan with a mortgage or lien on the non-exempt assets he wants to protect. The bank records the security instruments which gives the bank’s security interest priority over judgments against the debtor subsequently obtained by other creditors. In order for these other creditors to attack the encumbered asset, they would first have to pay off the amount of the lender’s secured loan.
- Equity stripping is a financial asset protection tool to reduce the equity in an otherwise exposed asset.
- Equity stripping requires favoring a friendly creditor over a more threatning creditor.
- Equity stripping works best with assets that are regularly pledged as collateral, such as real estate, but can work to reduce equity in business assets as well.
Understanding Equity Stripping for Asset Protection
Pledging a valuable non-exempt asset to secure a new loan essentially drains the equity from a non-exempt asset and permits the debtor to move the cash borrowed beyond the reach of creditors. Exempt assets, such as a Florida homestead or retirement plan, should not be pledged to borrow new money because these assets are already protected from creditors and cash obtained from a loan secured by an exempt asset may become unprotected.
Equity stripping is useful in certain situations. Business owners or professionals often have large accounts receivable or valuable equipment which cannot be assigned or titled in other names. Banks giving lines of credit almost always ask for a first secured position on a business’s receivables and equipment because these are the most liquid and valuable business assets. The bank’s security interest is established and recorded when the line of credit is established even though no money is lent to the debtor. The business can borrow money on the line of credit if and when it perceives a legal problem. Money borrowed through a line of credit is not protected from creditors, and the business must find other means to protect the borrowed funds such as distributing money borrowed to the business owners to pay principal on their homestead mortgage.
Equity stripping is used by people moving to Florida who mortgage their existing home and use the proceeds to purchase a Florida homestead. Another example is a real estate investor who owns multiple properties with equity. Changing title to multiple properties involves the expense of setting up new legal entities and substantial transfer taxation. An alternative is to buy new properties with loans cross-collateralized by presently owned properties which are otherwise unprotected.
Tip: Converting non-exempt equity in one state to a Florida homestead is generally immune to fraudulent transfer and conversion claims.
Alternatives to Equity Stripping for Asset Protection
Financial planning and asset protection in Florida refers to using financial tools in addition to, or in place of, legal tools. Many financial products provide Florida residents asset protection in addition to financial planning and retirement benefits. Four such important financial tools that are alternatives to equity stripping are leveraged annuities, regular annuities, cash value life insurance, and leveraging business accounts receivable.
Annuities are protected from judgment creditors under Florida Statute, §222.14. There are financial tools that combine asset protection of annuities with sound financial planning. One such tool is annuity arbitrage. Annuity arbitrage is a financing planning tool that enables older debtors in good health to fully fund life insurance for their descendants and generate cash flow protected from creditors during their lifetime. The life insurance, the annuity, and even the annuity proceeds paid to the debtor are protected from creditors.
Immediate annuities involve a lump sum investment in an annuity contract in exchange for a guaranteed income stream. The amount of the income stream is based on prevailing interest rates, and most importantly, on the age and health of the annuitant. Annuitants with a shorter life expectancy because of age and health typically are offered larger periodic payments. Life insurance premiums are also based on the insured’s life expectancy. Different companies selling either immediate annuities or life insurance contracts sometimes use different mortality tables and make significantly different judgments on a person’s life expectancy. When the annuity issuer assumes a shorter life expectancy than the life insurance issuer, the applicant has a financial opportunity.
Sometimes an experienced and astute financial professional can match individuals with particular annuity companies and life insurance companies to create a meaningful divergence in life expectancy assumptions. When the annuity company is convinced of a relatively shorter life expectancy, the applicant’s health, although not necessarily perfect, is good enough to warrant life insurance based on a relatively longer life expectancy. The annuity income stream will often exceed life insurance premiums. In such an event, the immediate annuity will provide payments in excess of life insurance premiums. The immediate annuity will fund the life insurance and provide the individual with a cash flow sheltered from creditors. The life insurance policy is typically owned by a life insurance trust to keep the insurance outside the insured’s taxable estate and to protect the death benefit from the beneficiaries’ creditors and former spouses.
The profit potential from this investment is important in defending creditor attacks of fraudulent conveyance. Suppose the creditor argues that a debtor purchased the annuity and insurance to shelter money from creditors. In that case, the debtor can point out that the investment was made to take advantage of an unusual arbitrage opportunity to fund life insurance for estate planning purposes to generate cash flow for lifetime support. Only relatively sophisticated financial professionals can arrange a profitable annuity arbitrage. Individuals should only deal with financial advisers with demonstrated experience in successful annuity arbitrage as an improperly structured arbitrage arrangement may have adverse income tax consequences.
Asset protection is available by purchasing international annuities. In particular, Switzerland and Liechtenstein laws guard annuities against attack by creditors from outside countries, including the United States. Swiss law, for instance, provides that Swiss annuities are not part of a debtor/owner’s bankruptcy estate even if a foreign (U.S.) court expressly directs liquidation of the annuity policy. Swiss and Liechtenstein fraudulent conveyance statutes provide that a fraudulent conveyance claim against their annuities must be brought in their country’s courts. Purchasing an annuity in the U.S. as well as offshore may more easily be defended against fraudulent transfer allegations as being a prudent financial planning tool.
Accounts Receivable Financing
Accounts receivable are often a business’s largest liquid asset and are also an attractive target of creditors of either the business or its individual owner. A creditor can garnish accounts receivable before they are paid, or the creditor can wait until after collection and garnish the proceeds deposited in the debtor’s bank account.
For many years, financial advisers have sheltered accounts receivable by “factoring.” Factoring means pledging the receivables for loans from institutional investors at a discount from the receivables’ face value. The discount provides the lender a security cushion against collection problems and considers the time required for collection and receipt. The lender takes a security position in the accounts receivable as a condition for the money loan. The lender’s secured position in the receivables has priority over subsequent judgment liens against the same receivables.
The challenge for the debtor who pledges receivables for a loan is the subsequent protection of the loan proceeds received. Distribution of the proceeds to the owner leaves the money vulnerable in the owner’s hands, and if the business is the debtor, the distribution out of the business account to the individual owner may be challenged as a fraudulent conveyance. Many financial professionals encourage debtors to use the loan proceeds to invest in life insurance purchased by the business on the owner’s life.
Another alternative entails an institutional loan to the individual business owner secured by accounts receivable and the purchase of annuities. Instead of the business being the borrower, the individual owner gets a loan directly from an institutional lender. The owner arranges for the business to provide its accounts receivable as collateral for security. The owner then arranges for the purchase of an annuity in his individual name. The annuity may be pledged as additional loan collateral. Initial loan proceeds are paid not to the owner of the business, but are wired directly to the issuer of the annuity. This arrangement provides a better defense against fraudulent conveyance allegations because neither the business nor the owner has possession of the loan proceeds in their bank accounts. Annuities are a better asset protection tool than life insurance because Florida Statutes protect not only the annuities themselves but also annuity proceeds after they are paid out to the owner/beneficiary so long as they are traceable.
Non-Recourse Life Insurance
Cash value life insurance on the life of a Florida debtor is exempt from creditors under Section 222.13, Florida Statutes. Non-recourse life insurance is a creative financial tool which incorporates life insurance policies financed by third-party investors whereby the insured benefits from cost-free, risk-free life insurance with the added opportunity to profit financially during the insured’s lifetime.
A key element of most life insurance contracts is the contest period during which a life insurance company may challenge a policy application and refuse to pay death benefits in the event of the insured’s death (most policies have a two-year contest period). Two years after issuance of a policy the death benefit “vests” so that benefits may be paid upon the insured’s death regardless of mistakes or misrepresentations about the insured’s health on the insurance application.
There are private and institutional investors who will invest money for the insured’s purchase of a life insurance policy with the expectation of the policy’s appreciated value following the two-year contest period. These investors will advance initial premiums on a condition of repayment, with interest, at the end of the contest period or upon the insured’s death within the first two years.
Other investors, primarily institutions, find financial opportunity in purchasing large, vested insurance policies at the end of the contest period. A large, two-year-old life insurance policy has value to third-party institutional investors especially when the insured’s life expectancy is relatively short by virtue of advanced age or poor health. These institutional investors purchase select vested life insurance policies for cash with the expectation of receiving death benefits in a relatively short time. The purchase and sale price are set at a discount of the full death benefit depending upon the insured’s age, health, and other financial considerations.
Combining an eligible insured, an investor willing to speculate on the policy purchase, and institutions in the market for vested insurance policies creates a unique opportunity for cash-free investment in a creditor protected financial vehicle known as “non-recourse life insurance.” The benefits and options in non-recourse life insurance change during the term of the policy. At the outset, an investor lends money to a life insurance trust created by the insured for initial premium payments. If the debtor/insured dies within the initial two-year contest period, the investor is repaid its investment loan, plus interest, from the death benefit, and the balance of death benefits are paid through the insurance trust to the trust beneficiaries. At the end of the contest period, the debtor has the option of selling the policy to a different institutional investor or repaying the initial premium lender and walking away from the transaction. In that case, the debtor has enjoyed free life insurance coverage for the preceding two years. The debtor/insured also has the option to repay the initial investor with his own funds and take over future premium payments.
A more profitable option for the debtor/insured at the end of the two-year contest period is to sell the policy to an institutional investor. Two years into the policy, the death benefit is vested and the debtor’s life expectancy is at least two years less than it was upon policy issuance. If the insured’s health has deteriorated during the two-year contest period, the value of the policy is even greater. In any event, the now-vested life insurance policy has enhanced value which the debtor/insured can realize through the sale of the policy to financial institutions. If the vested policy is sold, the initial lender/investor is repaid with interest at the sales closing, and the investor is responsible to pay future years’ premiums. The debtor/insured’s trust keeps all sales proceeds over and above lender repayment and accrued premium liability. Upon the insured’s death, the investor receives the death benefits.
Non-recourse life insurance provides the debtor/insured creditor protected financial gain with no cash outlay or liability as well as free life insurance during the two-year vesting period. This financial vehicle is, however, not available for all people. Only certain individuals with a certain financial net worth, age, and health profile qualify for issuance of large life insurance policies attractive to initial lenders and long-term institutional financing. Younger individuals in good health who themselves are not a candidate to profit from non-recourse insurance because of their long life expectancy often assist their parents or grandparents in earning money through this financial product.
Non-recourse life insurance is extremely complex and involves substantial legal documentation. An improperly structured program could have adverse income tax consequences. Individuals interested in pursuing creditor-protected investment in non-recourse life insurance should consult financial professionals experienced with this sophisticated financial product.