Equity Strips

Whether you are looking to protect a personal residence or investment real estate, you have to realize that creditors do not pursue the real estate itself, but the equity in the real estate. Creditors have to foreclose on the real estate, which means the real estate will be sold by a sheriff. On the foreclosure sale, after the payment of secured liens (like a bank mortgage), after paying the sheriff’s expenses, and after paying to the debtor the homestead exemption amount, the remaining equity goes to the creditor. Consequently, it is the equity that gets converted into money and given to the creditor. Not the real estate itself.

If the real estate has no equity, then on a foreclosure sale the creditor will not get any money. For example: Your home is worth $1,000,000 and is encumbered by a mortgage of $800,000. You live in California and your homestead exemption is $75,000. The home is forced into a foreclosure sale, where it is sold to some buyer for $900,000. Of the $900,000, the first $800,000 goes to the bank to pay off the mortgage. Then some money goes to the sheriff, and then $75,000 goes to you. There is nothing left for the creditor.

An intelligent creditor can do this math ahead of time and will not try to push a home like this into foreclosure. As a matter of fact, many creditors will drop their lawsuit if they realize that there is no equity left to pursue. Consequently, many debtors look to eliminate (strip out) their equity.

There are two equity stripping techniques:

Actual Bank Loan

One way to strip out the equity is by obtaining a bank loan. The bank will secure the loan by recording a deed of trust against your property. This eliminates the amount of equity equal to the loan.

While this technique results in the elimination of equity, there are two problems. First, it is difficult to obtain a bank loan large enough to eliminate 100% of equity. Second, the cost of this asset protection technique is staggering. Assuming a $1 million loan bearing a 7% interest rate, the cost of this equity strip is $70,000 per year. (Debtors usually ameliorate the carrying costs by investing the loan proceeds at a comparable rate of return.)

Paper Strip

Another way to strip out the equity (frequently advocated by debtors), is to encumber the residence by recording a deed of trust in favor of a friend.

This avoids the carrying costs of an actual bank loan and can be done in any amount. With this technique it is important to know the intelligence and the aggressiveness of the creditor. Some creditors may stop trying to collect when they realize that there is no equity in the residence. Others may dig deeper, and if the debtor cannot substantiate the transaction as an actual loan, the deed of trust will be set aside by a court as a sham. The creditor will again have equity to pursue.

Posted in: Commonly Used Structures