The Homestead Exemption

April 13, 2006

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In many states, the most important asset exemption legally protects the homestead--a personal residence--from the claims of most creditors.

However, exemptions vary widely from state to state. The homestead exemption provides a good example of this variation and how it impacts asset exemption planning.

Moreover, a new federal bankruptcy law, as of October 17, 2005, places limits on certain homestead exemptions, further complicating matters. A state's homestead exemption now is limited to $125,000 if the debtor had only acquired the property's equity during the 1,215 days prior to filing bankruptcy. Property owned for more than 1,215 days is not affected by the new federal law.

Kansas, Florida, Iowa, South Dakota and Texas provide an unlimited dollar value homestead exemption. Florida and Texas, in fact, are well known as debtor-friendly states because of their homestead exemptions. The Florida homestead exemption was once considered especially valuable because a U.S. Court of Appeals had held that the exemption would apply even when the owner acquired or enlarged it with the intent of defrauding creditors. This is no longer the case because of federal bankruptcy reform. Homesteads acquired through fraud can no longer be protected.

States with no dollar cap on their homestead exemption do limit the exemption to a certain area of land, which is much larger in rural areas. For example, in Florida the exemption is limited to half an acre in a city and 160 contiguous acres elsewhere. In practice, this area limitation will only rarely be a factor.

In contrast, Delaware, Maryland, New Jersey and Pennsylvania provide no specific homestead exemption.

Most states offer exemptions between these extremes. Even here, however, the exemption can be anywhere along the spectrum. For example, the exemption is $5,000 in Ohio, $80,000 in North Dakota, and $125,000 in Nevada.

The federal bankruptcy homestead exemption is $18,450. Where a state's homestead exemption is lower than $18,450, a debtor contemplating a bankruptcy filing should consider using the federal exemptions (if the state law permits it), all other things being equal.

The homestead exemption is considered such a basic and important right in some states, including Florida and Texas, that it is mandated by the state's constitution. This prevents the state's legislature from modifying or repealing the exemption by statute.

Generally, consensual liens, such as mortgages, cannot be eliminated inside or outside of bankruptcy, even when they are attached to property subject to an exemption. Thus, the homestead exemption can actually be worth nothing to the debtor if the home is very heavily mortgaged. In addition, remember that bifurcation or lien splitting usually will not be possible in a bankruptcy proceeding with respect to mortgages secured solely be a residence.

Nevertheless, where the homestead exemption is generous (e.g., in Florida or Texas), it will probably provide the greatest opportunity to shield wealth from creditors.

To exploit this exemption most effectively, the small business owner should employ the following strategies:

When the homestead exemption is unlimited, or the amount of the exemption exceeds the value of the home, consider paying off the mortgages on the property.
Where the value of the home exceeds the exemption amount, consider the opposite strategy; that is, encumbering the home with an additional commercial mortgage, or private mortgage from your business's holding entity.
Where there is no homestead exemption, or the homestead exemption is extremely low, consider owning the home with a spouse in tenancy by the entirety, if the state allows this. It's important here that you consider this option only after carefully weighing the risks of divorce.

Work Smart

Some states require individuals to record their homestead exemption at the county recording office, or wherever legal documents are normally recorded in the state. If the exemption is not recorded, you may not be able to use it. In some of these states, recording must take place before a bankruptcy filing, while in others, recording must occur before a forced sale of the home.

In some states, recording is optional, and may give you no greater rights than if you hadn't filed the papers.

It isn't necessary to sort out all of the differences. If recording is allowed or required, you should simply record your homestead exemption.

The following states allow, or require, the recording of the homestead exemption: