If Your Home's Value Exceeds the Exemption

April 13, 2006

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When the homestead exemption is limited and the value of the home exceeds the exemption, this strategy should be employed: Keep the home encumbered with first or second mortgages. The amount of consensual liens (and other non-removable liens) on the property should always equal or exceed the difference between the value of the home and the exemption amount.

Because this difference represents the total amount of liens that cannot be eliminated, any judicial liens then added to the property will be subject to elimination. Essentially, this practice makes the home judgment-proof, even though the homestead exemption is limited.

Let's say Peter Jones has a Nevada home worth $325,000 that is subject to a $100,000 mortgage.

The amount of liens that cannot be eliminated is equal to the value of the property ($325,000) less the amount of Nevada's homestead exemption ($125,000), or $200,000 in this case.

Jones is carrying only a $100,000 mortgage at this time. Thus, at this time, the home may potentially be encumbered by an additional judicial lien of up to $100,000.

For every dollar that Jones pays off the mortgage, another dollar becomes potentially available to a judgment creditor.

Instead of concentrating on paying off the mortgage, Jones should consider encumbering the home with a second mortgage in a minimum amount of $100,000. Then, the two mortgages would consume the full $200,000 of liens that can't be eliminated. Thus, this strategy would mean any judicial liens that were added to the home later could be eliminated.

Because the principal due on each mortgage will decrease as it is paid off, an even better approach would be to take out a second mortgage in an amount above the minimum.

Extreme caution, however, is required when taking out second mortgages or refinancing a home, because mortgage liens cannot be eliminated in or out of bankruptcy, and they cannot be bifurcated in a bankruptcy proceeding.

The risk here is obvious: If the second mortgage were not paid, the residence would be lost to foreclosure. A second mortgage should only be considered when you are absolutely sure you can pay back the loan.

If you choose, you could combine this strategy with even more advanced strategies. One strategy involves using a holding entity and an operating entity to operate your business. In that case, the wealth of the business would reside in the holding entity, which has no exposure to liability, while the operating entity, due to its exposure to liability, would not contain vulnerable assets.

In employing this strategy, you may want to consider taking a personal loan from your business's holding entity, while providing the holding entity, in return, with a demand promissory note secured by a mortgage on your residence.

In this strategy, the holding entity would normally not demand payment on the note, thus ensuring that the lien will remain on the residence. The holding entity would end up holding a valuable asset (i.e., the note and mortgage). However, because the holding entity does not conduct operating activities, the risk of loss here is minimal.

In other respects, the strategy described above is the same. Thus, in the last example, Jones would take a $30,000 loan from his holding entity, granting the holding entity a $30,000 mortgage in his residence.

In either case (a bank mortgage or a private mortgage), the business owner would have to consider how to employ the proceeds from the loan. One possibility, is to use the cash to make a loan to the operating entity, in which the operating entity grants liens on its assets to the owner (i.e., the holding entity) as security for the loan. This use of the proceeds ensures that the operating entity's assets are protected from creditors (because they are encumbered by secured loans from the business owner), despite the lack of asset exemptions, which are only available to natural persons, not business entities.

Warning

The strategy of obtaining a private loan from your business that is secured by a mortgage on your home should never be executed if only one business entity (an operating entity) is used to operate a business.

A mortgage on your home in favor of an operating entity would create a significant asset (i.e., the mortgage on your home) in the operating entity that would be exposed to liability, in the form of the claims of the business's creditors. If the operating entity's creditors were able to secure a judgment against the operating entity, they might be able to reach, and therefore foreclose on, your home mortgage.