Equity Stripping is an asset protection technique that enables a property owner to retain title to property while stripping out and transferring to a third party the excess unencumbered and non-exempt value (the "Equity") of the property. A simple equity stripping example is obtaining a mortgage on a home. If the fair market value of a home is $400,000 and the homestead exemption in the owner's state of residence is $100,000, then if there were no mortgage on the home, a creditor could place a lien on the property for the entire value of the home that is in excess of the homestead exemption, i.e., $300,000. If in contrast, a mortgage is obtained in the amount of $300,000, then the creditor would be unable to make any claim to the property because the homestead exemption and the mortgagee's first priority interest are equal to the entire value of the property.
By stripping out the Equity of the property the owner could be exposed to foreclosure of the property if he fails to make mortgage payments when due, but, he can counterbalance this risk by investing in other bankruptcy exempt assets such as life insurance, qualified retirement accounts or in charging order protected entities such as LLCs or partnerships that produce operating income. The point of equity stripping is not to produce cash that is used in non-productive ways, but to redirect that cash so that the owner is in a stronger asset protection position if claims do arise.
Mortgaging a home is the most common equity stripping alternative used, but this technique can be used with many different assets such as investment property, accounts receivable, inventory, and intellectual property such as trademarks, copyrights and patents. The technique can also be used in conjunction with estate planning tools to shift wealth outside of an owner's taxable estate by, for instance, having a family trust issue the loan to the individual or entity so that interest income and fees are earned by the trust.
While equity stripping is a valuable tool, it does have disadvantages, some of which include:
- Most types of property are not exempt, or have very low exemption levels, under state debtor/creditor and federal bankruptcy laws. As a result, creditors may force a sale of the property even if another entity has a first security interest. This outcome is more probable if the creditor believes a sale will yield a recovery. Thus, failing to continually strip excess value runs the risk that the asset may nevertheless be lost.
- Equity stripping exposes the owner to being "under water" if the property depreciates below the outstanding balance of the loan. This is more likely with aggressive equity stripping in relation to assets which are in volatile markets.
- The assets in which in which the Equity are invested could decline in value (some cases significantly) or yield a lower return than interest charged on the loan. In such cases the owner could be in a worse position (particularly if no creditor materializes) than if equity stripping had never been undertaken.
Equity stripping is one technique to effect asset protection. In practice, equity stripping can take many forms and be used in creative ways to leverage and protect assets. As with every alternative, however, there are trade-offs that require careful consideration.