Protecting Your Home From Lawsuit Risk
Robert J. Mintz, Esq.
For many people, the family home still represents the largest source of wealth and personal savings. Dramatic increases in housing prices has made protecting the home from lawsuit risk a key issue in asset protection planning. Clients are now coming to us with substantial equity in their residence and may own one or several vacation homes and rental houses.
What should we do to protect these valuable properties from the risks of a potential lawsuit? In previous articles I broadly described some of the popular strategies used for asset protection such as different types of trusts, family limited partnerships and limited liability companies. The question today is how to protect the family home from lawsuit risks. Note that a residence is treated differently for asset protection and tax purposes than a rental property, so in this article we will focus just on the home. Next time we will deal specifically with the protection of rental properties.
A residence has certain unique legal attributes which are unlike any other type of property. Homes have a distinct set of tax and legal considerations which don’t apply to any other type of property. Rental real estate has its own characteristics and savings and pension are treated still differently. To protect the home from liability risk several key factors must be considered.
As you know, there are strong tax advantages from home ownership although these benefits have been weakened by the 2018 tax act. While you are living there you are entitled to a mortgage interest deduction up to the limit on deductions and when you sell you can exclude up to $500,000 of gain (for a married couple). The deductibility of property taxes is now subject to the overall $10,000 limit for deductions on state and local taxes. The requirement for any deductions for tax purposes is that you are the “owner” of the residence. If we create a plan which removes you from ownership these tax benefits can be jeopardized. So care must be exercised in the planning stages to choose the appropriate strategy to avoid inadvertently losing the available tax advantages.
A number of states prohibit a local property tax reassessment as long as you own your home. For instance, California is one of the states which does not allow a reassessment to a higher value unless there has been a “change of ownership” of the house. This law stops the county assessor from raising your property taxes every year when the house increases in value. Those who bought their homes many years ago, for $100,000 would not be able to afford to pay property taxes based on a new valuation of $1 million. California and other states prohibit a change in the property taxes unless the house is sold or there is some other “change in ownership” which can include a transfer to a trust or other entity. If your state law protects you from these increased taxes, any strategy for protecting your home must avoid triggering a new property tax assessment by carefully following all of the rules.
It will be important that you maintain the ability to live in your home even when it is in the asset protection plan. The situation is a little different with rental real estate or retirement savings which you may not need to use until some time in the future. Clearly, you need to live in your home now but you don’t necessarily need to use the income from your investments while you are working. There is no question about it, when we deal with an asset that is reserved for current use, protection of that property is more difficult and requires considerably more thought. Whenever we do our planning we have to take this fact into account.
Depending upon the state where you live, certain legal protections for your home already exist. The law of each state exempts from a judgment a specific amount of equity in one’s home. For example in New York it appears that the homestead exemption is only $10,000 for an individual and in California this amount is $50,000. Massachusetts has one of the higher amounts-$300,000. Florida and Texas go the furthest and provide actual protection for an unlimited amount of equity. Any amount at all-even millions of dollars cannot be seized by a creditor. The impact of these laws is that if the amount of the equity in your home is clearly protected under the laws of your state then no further planning may be necessary. Further legal protect is necessary only if you have equity which exceeds the amount protected by state homestead laws.
Plans Which Don’t Work
As I mentioned above, techniques which can be used for other types of assets such as investment real estate and savings are generally not effective for protecting the family residence. For example, if a family limited partnership or limited liability company is used, the IRS has ruled that some or all of these tax advantages may be lost. In addition, if a property within an FLP is reserved for personal use, the protection offered by the FLP might be challenged in a future lawsuit. The traditional strategy of simply gifting the home to ones spouse-will preserve the tax benefits- but is unlikely to accomplish anything on the asset protection side.
Solving the Protection Problem
With this background in mind the question we address in asset protection is how to protect equity, above the homestead amount, while preserving the tax benefits and the continued right to use and enjoy the house.
First, let’s take on the tax issues. Some trusts are treated by the tax law as if they do not exist. This type of trust is known as a “grantor trust” and if certain language is used in the trust document the IRS will treat you as the owner of the property, not the trust. That’s good and it is what we want for our purposes. We want a legal trust that is respected for protection purposes but that is ignored for taxes. That way we are assured that we’ll retain all the tax benefits. So, our first requirement is that the trust we use is treated as a “grantor trust.”
Once we have solved the tax problems we can consider the asset protection issues. To achieve worthwhile protection for the residence it is important that your legal rights concerning the house are limited in some manner. If you maintain the full spectrum of ownership rights, it is likely that a judge would order you to turn over the property to a plaintiff with a judgment against you. In other words, to the extent that you have unrestricted power to do anything you want with your home, it can be seized in a collection action.
The key to protecting the home is to limit your rights in some manner so that there is nothing legally available which can be reached. If your ownership of your home changes from full and complete to something less, your interest may have no value to a prospective creditor.
How should we limit your rights in an acceptable manner? We say acceptable because it is certainly easy to fully protect your home if you want to give it away to your children and not live there anymore. That’s perfect asset protection but in most cases it would not be a satisfactory solution. Maybe we can accomplish what we want using less drastic measures.
Personal Residence Trust
A Personal Residence Trust is a broad generic term we apply to a trust to hold property and apply restrictions which protect it against possible loss. This type of trust is designed to be ignored for tax purposes so that no tax issues are created and the tax benefits are preserved. There are many different formats and strategies which can be used for creating this type of trust, depending upon the particular circumstances of the case.
One popular technique is to provide in the PRT that your children or other family members take ownership of the house after a certain number of years. The trust reserves to you the right to live there for a period of time-perhaps 10 or 20 years. In addition to powerful asset protection advantages this arrangement, depending on the exact terms, may provide excellent estate tax benefits by freezing the value of the house at its current amount and removing it from your taxable estate. The period of years and the important terms can be modified or tailored to meet most circumstances.
Sometimes we reverse this arrangement if the circumstances are appropriate. Rather than reserving a right to live there for a period of years, the PRT can provide that the home belongs to the trust but can be leased back to you for a period of years. Although you would pay rent to the trust, the usual tax benefits would apply because of the grantor trust rules. At the end of the term of the lease, full ownership could be returned to you or passed to your children. It can go either way, depending upon your view of any future potential liability you may have.
In a slightly different vein, the PRT could be provided with an option to purchase or a right to exercise some other authority over the property within the trust. As an illustration, rather than a recommendation, assume your home is worth $1 million with a loan of $500,000. A Personal Residence Trust is created which grants the trust an option to purchase the property for the loan amount, any time within the next 15 years. The option agreement is recorded and acts the same as a lien on the property. The equity in the home cannot be seized by a successful plaintiff, since the home itself is subject to the option to purchase for the $500,000 amount. Under this arrangement you can live in the house without restriction and subject only to whatever terms are provided in the option agreement. There are a number of issues which must be addressed in this type of strategy but this illustration gives you an idea of the direction that planning can be taken.
Protecting the family home from the risk of lawsuits requires consideration of income tax and local property tax issues as well as your State homestead law. A Personal Residence Trust may provide a good solution for many of the tricky problems which typically arise when we are dealing with a home. For those who feel that they have some degree of lawsuit exposure and who have substantial equity in their home, one or more of the available strategies with the Personal Residence Trust may be a conservative course of action. As we always suggest, the particular circumstances of your case and developing a plan which is appropriate for you is a matter which must be discussed with your personal legal advisor.