Equity Strip Exposed

How To Strip Out Equity

The so-called “equity strip” is sometimes promoted as an asset protect device.  It is most often used with real estate.  However, it can be used with nearly any asset.  While an equity strip can have significant asset protection benefits, it also has much less aggressive uses for simple retirement cash flow, business succession planning, and estate planning purposes.

In accounting terms, “equity” is the value of an asset net of any liens or liabilities associated with that asset.  For example, if you own a rental property worth $100,000 that has a $75,000 mortgage, your “equity” in the property is $25,000 ($100,000 – $75,000 = $25,000).  If you owned this rental property free and clear, your equity would be the full fair market value of $100,000.

If you borrow money and use the rental home as collateral, you encumber the property with debt.  As a result, you “strip” out the equity.  This is true whether you get the loan from a commercial lender such as a bank or loan company, or from some other source.

Such a loan would have at least two essential documents:  a Promissory Note and a Security Instrument.  The Promissory Note should be commercial grade, and may be a “revolving credit line” note with draws, payments and a floating balance similar to a credit card.  The Security Instrument may be a Mortgage or Deed of Trust when dealing with real estate, or other forms of security such as a UCC Filing Statement, Guarantees, Pledge, Collateral Assignment, Business Security Agreements as appropriate for the asset from which the equity is being stripped.

Loan Enforcement

No matter who or what you borrow the money from, if you default on the loan, the lender can foreclose and take the property from you.  Likewise, because the lender is a “secured” creditor with a lien on the property, the lender will recover the equity in priority ahead of other claimants.

So, let’s say in addition to the $75,000 mortgage on the rental property, there is a second mortgage of $10,000 for a pool, and you have unsecured credit card debt of $20,000.  In this scenario, your total debt is $105,000.  If the rental property worth $100,000 is your only asset, you would be insolvent, because your debts or liabilities are greater than your assets or equity.   Upon a default, the house would be sold, and the proceeds divided among the creditors.  The secured lien holder with the $75,000 mortgage would recover first.  The $10,000 secured lien in second position and the unsecured creditor in third position may or may not recover anything.

Precisely how and how much the various creditors get paid depends on many factors including how and for what price the property is sold, whether or not there is a bankruptcy or other court involvement, and how willing subordinate lien holders are to spend time and money to enforce their interest.

The big difference is this.  If the secured loan is with a “friendly” party, that friendly party can recover the equity and “protect” it.  How much and what kind of protection you get depends a great deal on who and what kind of entity the lender is, what steps the lender takes to enforce its interest, and what the lender does after it recovers its loan and obtains the equity.

How to Screw Up The Equity Strip

There are several highly effective ways to set up an equity strip so that it will unintended consequences or will not work as desired.  Here are a few:

• Undocumented loans
• Unsecured loans
• Fake loans that are transparent attempts to not look like a fraudulent conveyance
• Loans between spouses
• Loans with yourself
• Loans with family or friends
• Loans with competitors, customers, employees, or business partners
• Loans with hostile or adverse parties

It is important that the loan be real.  Even when so-called asset protection is one of the purposes, the loan must be for valid consideration, commercially reasonable, and implemented for the purpose of increasing financial resources over time.  The expectation is that when capital is deployed and loans are repaid,  one’s ability to cover any claims that may arise in the future will be improved.

Candidly, it is surprising to us how often we encounter such misguided attempts.  The problem is, no one notices that it is a problem until it is a problem.  Doing it wrong will seem like it is working, until it isn’t.

Effective Equity Based Loans

There are many highly beneficial uses for an equity strip that may have the effect of protecting an asset, but really is not done for that purpose.  For example:

• Home Equity Line of Credit (“HELOC”).  This can provide cash flow and allow the home owner to use and spend the equity while keeping the home.  This can be a very powerful alternative to a reverse mortgage.
• Estate Planning.  For estate planning, removing the equity from a high priced asset such as a home or business can effectively remove such equity from the taxable estate, and yet leave the underlying asset itself in the taxable estate so that it gets a step-up in cost basis at death.  This has significant advantages over other strategies such as simply giving away the house and/or a Qualified Personal Residence Trust (“QPRT”) which amounts to giving away the house over a fixed term and they paying rent.  Interest paid to a Trust or entity outside the taxable estate can reduce future tax obligations and result in more net net value to the family over time.
• Financing a Business.  This can be either for purposes of purchasing a business or simply for providing capital to grow a business.  The loan can be secured with business assets such as inventory, equipment, receivables, and even valuable intellectual property.
• Succession Planning.  When a business or high priced asset is going to be sold as part of a succession plan, depending on the buyer, there are times and ways in which an equity strip can facilitate or accommodate the transaction.  Less equity to buy and sell means a lower purchase price, and equity strip debt can be paid over time.

Best Lenders

This is a partial list of potential lenders for an Equity Strip Loan (excluding commercial lenders), ranked in order of best to worst:

• “Family Bank“
• “Irrevocable Dynasty Trust“
• Properly Structured Business Entity
• Off Shore Entity (this can be particularly powerful, but has its own costs and compliance issues which can be substantial)
• People Who Hate You and Want to Destroy YOU
• Friends
• Family Members (notice, this is ranked last in priority, after people who hate you.  Find out why!)

Not A DIY Device

There are so many variables, and so many ways to do it both right and wrong, it is best not to implement an Equity Strip as a Do-It-Yourself project.  Most of the time structures such as this are part of a comprehensive business and estate plan.  It is not readily separated from all the other elements that make it possible.  Get professional help.