Basic Strategies to Protect Your Assets

1. Introduction

In this article, you will be exposed to methods of protecting yourself, your assets and your estate from those tenants, creditors and/or attorneys who are eager to take your wealth away from you.

As it turns out, most people who contemplate filing lawsuits will only go ahead and sue if they think they can actually get something from you. Attorneys will usually encourage their clients to pursue only as far as an insurance company is willing to pay. This usually means doing a lot of work and waiting a long time before there is any meaningful reward.

If your plaintiff's attorney is working on a contingency basis, he or she is not too eager to put in too much time or effort due to the risk of winding up empty handed. On the other hand, if the plaintiff is paying for the attorney out of their own pocket, they are not eager to spend too much time and/or effort either; they'll be footing the bill and they might not win anything in the end.

That is why insurance should always be your first line of defense. In most situations, having the right kind of insurance and the right amount will save your fortune and thus your estate.

However, every once in a while, your creditor will not be satisfied with just an insurance settlement, or worse yet, insurance will not cover the particular type of creditor's claim. For these latter types of situations, the only potential for saving your fortune and estate is a formal asset protection strategy.

2. Encumber or Transfer

Asset protection, in simple terms, means protecting what you have from those who want to take it away from you. It turns out that after you spend a lot of time and money learning about asset protection, you will find that there are only two workable strategies.

The first and easiest is to encumber everything you own so that nothing you own has any value. Think about it: Who in their right mind will go after something you own if that something will have no value when they get their hands on it?

The second technique utilized in a formal asset protection strategy is to transfer whatever wealth you have in such a way that even if your creditor is successful in getting a judgement against you, there is no way to access your assets.

Remember that in most situations people are only going to pursue you if they know that you have something of value they can take away. Therefore, successful asset protection strategies will either “encumber or transfer” your accessible wealth. It’s that simple.

How much asset protection is right for you, and what type, depends on your particular facts and circumstances. Asset protection questions should be addressed to competent attorneys who specialize in the field.

In looking for such attorneys, though, it is important to realize that no two attorneys will agree on or recommend the same strategy. Most attorneys are familiar and experienced with only one particular strategy. As far as they are concerned, their strategy is the only workable one.

Solicit a number of proposals and carefully review the alternative strategies until you feel comfortable with one that makes sense for your particular set of acts and circumstances.

The following is a discussion of some of the more popular strategies to protect your assets. Remember, to protect means to “encumber and/or transfer” your wealth in such a way as to limit anyone’s ability and/or desire to get at what you own.

3. Is Owning Free and Clear the Best?

Most of us have always felt that the best way to own rental real estate is to own it “free and clear.” That way our income potential is greatest, since the property is not burdened with debt service (i.e., mortgage payments).

However, by owning the property free and clear we are exposed to the potential for a large loss. A big earthquake can demolish the property. Similarly, a sizable judgement from a lawsuit can take the building away from us. If, however, the property is fully encumbered, neither a quake nor a judgment will do much damage. Our loss will be both contained and minimal.

Practically speaking, let’s say that we own a $1 million building free and clear. In today’s market, let’s assume that we are earning 7% return on our equity. That means that on a pre-tax basis we are earning $70,000 a year. If we could borrow all of our equity out at a rate of 7% and invest it in something that earns 7%, our pre-tax earnings will net out to the same $70,000.

However, our risk exposure from the building will be significantly reduced. With all of our money sunk in the building, casualty or a lawsuit could have cost us the whole thing, or $1 million. Now we stand to lose nothing on the building (since our equity in the building is zero).

Your reaction to the above example will most likely be:

a. You cannot borrow all your equity out of the building because no one will lend you 100% of your equity; and

b. What is to stop your creditor from pursuing the money that you borrowed in satisfaction of the judgement? Good points!

In response to borrowing 100% of the equity, practically speaking, it is not necessary. Even if you borrow 80% of the equity, very few creditors will be willing to take over such an encumbered property due to the management risk and the costs associated with selling the building.

As far as pursuing the funds that you have previously borrowed, this is where the transferring takes place. Who says that you have to have outright and/or immediate possession of the money.

It is very easy to invest the funds in a conventional investment such as an annuity where you do not own the money any more but only have the rights to an annual income stream. If you are clever, though, you will transfer the funds to a holding entity that you can control in such a way as to totally frustrate a creditor should they try to pursue the money.

This brings us to the next element in our asset protection strategy, namely the holding entities for our wealth and estate. Most asset protection strategies involve the use of holding entities. These entities are typically trusts, partnerships, and/or corporations. Very recently, the limited liability company (LLC) has also been introduced for this purpose.

The purpose of a holding entity is to isolate liability and thus contain its negative consequences. In plain English that means that if something within an entity creates a liability, such a liability will not escape the entity and contaminate your other holdings.

As an example, if you own an apartment building within such an entity, someone who is injured by the building cannot pursue anything you own outside the entity in order to satisfy a judgement.

The only recourse they have is the building. If the building is, practically speaking, worthless due to encumbrances, then the creditor will be forced to settle for nothing.

At this point it is worthwhile for you to become a little skeptical and ask yourself the question: “If these strategies work so well, why isn’t everyone doing this?” Good question.

Not everyone, you see, is concerned about asset protection, the reason being they have not been personally attacked by a frivolous lawsuit. Up until now, they have either been very careful or very lucky.

Besides that, asset protection is not cheap. Just as insurance has a cost by way of the annual premium, asset protection has an associated cost. To implement an asset protection strategy requires the use of attorneys.

The fees that attorneys charge depend on the time they spend and the level of the strategy’s complexity. We have seen these fees range from as little as $1,000 to as much as $50,000.

Once the entities are created, they require annual maintenance. The annual maintenance can consist of legal and accounting fees, which can range from as little as a few hundred dollars per entity per year to as much as several thousand dollars per entity per year.

When all is said and done, is it worth it? At this point one is reminded of the famous question that all accountants are asked when they are being interviewed by prospective clients: “How aggressive are you?” An often used answer is: “It depends on whether you like to eat well or sleep well.

If you like to eat well then we can be very aggressive and save you a lot on taxes! If you like to sleep well then we will be more conservative and not save you as much on taxes!”

Here is the analogy as it relates to asset protection: If you would like to be well protected, just in case, then it will cost you money and make your life more complex by implementing a strategy. If you don’t worry too much abou the potential of judgements against you then forget about these asset protection strategies.

Of course, there is a middle ground too. Some asset protection strategies are less costly and less cumbersome to implement than others and perhaps are worthwhile pursuing. As it turns out, most asset protection strategies have a very favorable side effect on your estate tax exposure: reducing your tax liability!

RealTax professionals have the competence and experience to help you protect your assets. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.