Protecting Your Assets Under the New Bankruptcy Act
Robert J. Mintz, Esq.
Strategies for protecting homes and savings from lawsuit risks have been impacted by sweeping changes in The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. For those concerned with the issue of minimizing legal exposure, some of the changes are positive and others are clearly unfavorable to certain types of plans. Since asset protection is an important topic, in this article we’ll look at the key points in the new law which may affect your current or future planning.
Protecting your home
The biggest impact concerns the amount of equity in your home which can be protected from a judgment. We have discussed before (see “Protecting Your Home From Lawsuit Risk”) that most states allow some or even all of the equity in a principal residence to be shielded from a lawsuit judgment. This is called the homestead amount and it varies considerably from state to state. For example, Maryland has no protected amount. In New York, it is just $10,000 while Nevada exempts up to $200,000. Massachusetts is among the more liberal, allowing $300,000 to be protected. Several states, namely, Florida, Texas, Kansas, Iowa and Oklahoma allow an unlimited exemption.
This unlimited homestead has long been a sore point with the banking industry and many trial attorneys, who were often frustrated in their attempts to collect on their judgments. An individual, suspecting that he might be facing financial problems or a large damage award, was able to move to Florida or another unlimited homestead state and plow all of his savings into a residence. As long as legal residency was properly established, the equity was then protected-without any restriction on the amount. For instance, Dr. A lives in West Virginia and owns a house worth $300,000 and $700,000 in savings and other property. He is named in a lawsuit with big potential damages but the West Virginia homestead protects only $25,000 of home equity. As a result, Dr. A is at risk for most of what he owns. Instead, of risking everything on an uncertain outcome to the case, he moves his family to Florida and buys a home for $1,000,000. The intent is to use the Florida homestead exemption to free him from the threat of the existing lawsuit.
These unlimited homesteads were always viewed as an effective and popular worst-case scenario. Moving the family and practice to another state may be inconvenient, but if it’s the only choice, it is better than handing over everything to the plaintiff’s attorney. During the past ten years, this so called “Florida Option” has been the choice of many prominent CEO’s as well as others attempting to avoid financial ruin.
The new law, which applies to bankruptcy filings, curbs this perceived abuse by limiting the exemption to $125,000 for amounts invested in a home within the prior 40 months. Even if the state homestead amount is more than that or is unlimited, amounts invested within the 40 month period can only be shielded to a maximum of $125,000. That time period is therefore critical. Someone who develops business problems or fears a lawsuit with substantial damages won’t be able to escape the judgment by sinking large amounts of cash into a homestead protected house. Anything above $125,000 will remain available for the creditor. Only those with enough foresight or luck to invest in a residence more then 40 months before a judgment will be able to take advantage of the full exemption.
Even if you are already a long-term resident of an unlimited homestead state, if you buy a new, more expensive house, the additional investment, beyond the $125,000 is not protected. For example, Dr. X has lived in Florida for 20 years. In 2006 he sells his home for $1 million and buys a new home for $2 million. He loses a lawsuit in 2008. His new investment of $1million within the previous 40 months is only protected to the limit of $125,000. Similarly, using savings to pay down a mortgage to obtain homestead protection for the funds won’t help if it’s done within the 40 month window.
The impact of bankruptcy laws
Under what circumstances would these changes in the bankruptcy law be important to you? The new law on the homestead exemption and the other matters discussed below will only affect you in a bankruptcy situation. For example, if there was a judgment against you or other debts you couldn’t pay bankruptcy generally allows you to eliminate the amount of these claims. You would have to forfeit all of your assets that were not exempt or otherwise protected in an asset protection plan, but “cleaning the slate” with this strategy would permit you to earn an income in the future, free of all judgments and other debts. Whether bankruptcy is a good legal strategy usually depends upon a careful analysis of the amount of the debt or judgment, the amount of unprotected assets-subject to seizure- and the future income available to you.
A couple of examples can illustrate the point. Dr. Z has income of $200,000 per year; a home with $125,000 of equity and a recent judgment against him for $500,000. If he does not file for bankruptcy his house will be protected to the extent of his state homestead exemption. He may not lose that equity, but his future income and any amounts he saves will be subject to collection by the judgment creditor. Since a judgment is generally enforceable for 20 years, Dr. Z faces a rather bleak financial future. Alternatively, he can file for bankruptcy, protect his home under the homestead exemption, extinguish the outstanding judgment, and whatever he makes or saves in the future won’t be jeopardized. From a financial and legal standpoint, without considering other business factors, a bankruptcy filing is most likely the correct strategy in this case.
In other situations the analysis might be more difficult. What if Dr Z also had $300,000 of cash savings? If he were to file bankruptcy he would lose all of his savings in exchange for a discharge of the judgment and to free his future earnings. The correct move in this case is no longer perfectly clear. Maybe he can avoid bankruptcy altogether by negotiating a satisfactory settlement. Perhaps there are asset protection techniques that are still available. Bankruptcy issues and maximizing asset protection are often fairly complex matters and tax, legal and business considerations should be carefully balanced.
Other planning factors
There are a number of other important changes in the law which might be significant for your asset protection planning. We will cover these issues in more detail in our future columns but some key changes to note are:
- All qualified retirement plans are fully exempt in bankruptcy. IRA’s are now also shielded, up to a maximum of $1,000,000 plus any amounts rolled over from a qualified plan. With this new level of protection, designing an appropriate retirement plan may be an important part of an asset protection strategy.
- A popular asset protection technique, known as a self settled asset protection trust, can be set aside in bankruptcy if it was established within 10 years and intended to hinder, delay or defraud a creditor. These types of trusts are typically Delaware or Alaska trusts or sometimes created as offshore trusts. The planning may be very sound when established early and with the proper motivation but existing self-settled trusts should be reconsidered with proper regard for the new law.
The new bankruptcy law creates some changes in the asset protection landscape by favoring particular strategies such as retirement plans while making the homestead exemption more complex and subject to delicate timing issues. Asset protection planning should always consider the impact of bankruptcy law in determining the techniques which will be effective in the widest variety of circumstances. As always, we urge you to consult with your attorney or other advisors to make sure that your planning is appropriate and up to date with the latest cases and legislation.