How to protect your home and home equity from liability
Along with retirement and personal investment accounts, the family home and its equity are often an orthopedist’s most valuable asset.
Moreover, with the white-hot 2021 real estate market, many physicians have seen the value of their homes increase significantly, potentially putting even more equity in a liability-vulnerable position.
Beyond its purely financial value, the family home has great psychological value. In fact, David finds that most clients who engage in asset protection planning begin by asking how they can protect their home. This is why we decided to dedicate an installment of this column to that topic.
Insurance for inside risks
Inside risks are those that threaten the home because of potential liability created by the home itself. This would encompass injuries on the property, such as slips or falls, pool accidents and liability for guests drinking at the home and then driving (including guests of teenage or college-age children). Although rare, these risks can be significant in terms of potential liability.
The best way to shield the home and other assets from inside risks is to use insurance — specifically, homeowners and umbrella coverage. Homeowners insurance is often required by lenders if there is a mortgage on the property, however required coverage amounts are a floor and may not be adequate for sufficient protection. Umbrella coverage should also be considered essential, even if it is not required by lenders. Given its low cost (millions of dollars of coverage can often be obtained for less than $1,000 annually), umbrella coverage is an efficient asset protector. One should be sure that the terms of the umbrella policy align with the homeowners and auto insurance policies, so there is no gap in coverage.
Tools shield home from outside risk
Outside risks to the home are potential claims against the homeowner — either the orthopedist or the spouse — for any reason. These types of risks are typically more common and top of mind for physicians and include potential claims for medical malpractice, auto accidents and contractual liability or claims that arise from personal guarantees. To shield the home and its equity from such potential claims, orthopedists have several tools, including state exemptions, co-ownership and legal tools.
State homestead law
As discussed in our previous columns, every state has a homestead protection law that states some amount of home equity is exempt from lawsuits and creditor claims. In a few states, homestead laws protect an unlimited value, although there may be some geographic limitations, in such states as Texas and Florida, for example. In states where homestead law protects an unlimited value, orthopedists need only to confirm that their home qualifies, and their home equity is fully protected.
In most states, however, including Illinois, New York and California, the value that homestead rules protect is low compared with what real estate is worth. On average, state homestead laws protect about $30,000 to $50,000 of equity — typically a small fraction of the value of most doctors’ homes. In those states, additional protection options must be examined.
Tenancy by the entirety
Often described as a “quasi-exempt” asset class, tenancy by the entirety (TBE) is a form of joint ownership for married couples available in several states. In essence, in the states that protect real estate well through TBE, the home will not be subject to any claims against one spouse. This can be invaluable to a married couple when one spouse has significant exposure (ie, orthopedic surgeon) and the other does not. Some limitations are inherent in TBE, including providing no protection for joint risks or for unmarried people.
Trusts for asset protection
There are many types of trusts that can be valuable in asset protection planning. When shielding a home, the two most popular ones are a domestic asset protection trust (DAPT) in states that allow them and a qualified personal residence trust (QPRT) available in all states.
About 20 states, including Ohio, Connecticut and Nevada, have adopted DAPT legislation. In these states, an orthopedist can set up an irrevocable trust and be a beneficiary of the trust. When there is no lawsuit concern, the physician can access the trust assets as the beneficiary, but if the physician has lawsuit claimants pursuing them, the trust is written so that the trustee cannot make distributions to the physician because they are “under duress.”
Because there are no distributions anyway, a DAPT can protect the home well. Additionally, the DAPT can be set up as a grantor trust, which means the trust is treated for tax purposes as if it were owned by the orthopedist.
In all states, orthopedists may use a QPRT to protect their homes. While this is effective for both asset protection and estate planning purposes, it comes with a significant cost. You no longer own your home. In fact, when the term of years is up (the typical range for a QPRT is 5 to 20 years), you must pay rent to the trust just to live in your home. Also, homes with mortgages on them present tax difficulties.
For these reasons, physicians must use experienced legal advisors when implementing DAPTs and QPRTs.
The debt shield can be an effective way to shield the equity of a home. Essentially, using a debt shield means getting a loan against the equity in the home. For many clients, this is counterintuitive, because they want to pay down the mortgage as much as possible, a process that may have emotional appeal. However, for asset protection purposes, it is the exact opposite of what one should do in states where homestead, TBE and trusts are not viable options.
For some orthopedists, using a debt shield does not mean taking a new loan on their home. Rather, it may mean not following a strategy of paying the mortgage down quicker than what is necessary. Regarding debt shields, in making the decision on whether, or to what extent, to pay down a mortgage, the physician should ask the following questions: Could the funds be invested in another, better-protected asset? Could the funds be invested in another better-performing asset? When getting a new loan is involved, the analysis is identical.
From an asset protection perspective, the transaction is simple. Use the debt shield to move the equity from the vulnerable asset (the home) to a better-protected asset. From an economic perspective, the decision process is also simple. Consider whether the cost of the equity move (the after-tax interest cost) is higher or lower than the return that the asset ultimately purchased with the loan proceeds can generate, along with the “safety” of the asset in which you are investing.
For most orthopedists, there is no more financially valuable and psychologically important asset than the family residence. Some states offer great homestead protection, but most states provide an inadequate shield. Potential options include TBE, trusts or some type of debt shield strategy.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Illinois. He can be reached at email: firstname.lastname@example.org.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at email@example.com or 877-656-4362.