The "homestead" exemption usually is the most important asset exemption, both in terms of amount and significance to the individual. However, the exemption amount varies widely from state to state, so it is important to understand how to maximize the protection offered by your state's law.
In general, the homestead exemption is both the most important and the largest asset protection exemption that is available. However, exemption amounts vary widely from state to state. The homestead exemption provides a good example of this variation and how it impacts asset exemption planning.
Federal bankruptcy law places limits on certain homestead exemptions, further complicating matters. A state's homestead exemption 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 federal law.
Kansas, Florida, Iowa, 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. However, homesteads acquired through fraud can no longer be protected.
Some states that do not have a 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 contrast, the District of Columbia, 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 $10,000 in Oklahoma, $80,000 in North Dakota, and $550,000 in Nevada (although this may be limited by the federal cap of $125,000 in some cases).
The federal bankruptcy homestead exemption is $22,975. Where a state's homestead exemption is lower than $20,200, 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.
It is crucial to remember that 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.
However, the homestead exemption is powerful protection for the small business owner who may face judgment liens from personal guarantees he or she provides for the business entity's contracts, or from torts, such as negligence or malpractice, committed while carrying out the business activities.
Homestead exemption must be recorded in some states
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:
Recordation of the Homestead Exemption
- Alabama
- Arkansas
- California
- Florida
- Idaho
- Iowa
- Massachusetts
- Michigan
- Montana
- Nebraska
- Nevada
- South Dakota
- Texas
- Utah
- Virginia
- Washington
Pay off consensual liens secured by home
A consensual lien, such as a mortgage, can attach to property that would otherwise be exempt. As a result, whether you are in state court or in bankruptcy you have the following choices:
- give the property up to the lien holder or
- keep the property, pay off any back due amount and continue to make payments on the mortgage.
To take full advantage of your state's homestead exemption, you should pay off all consensual liens, as well as any other liens that are not dischargeable in bankruptcy and that are secured by your home.
There are two major benefits to this action. First, the cash used to make the payment will be converted from a nonexempt asset (cash) to an exempt asset (a paid-off home). Second, at the same time, you will still be able to remove judicial liens (and other liens subject to elimination) from the residence since these kinds of liens impair the exemption.
Example
Cydney, a Florida resident, owns a home worth $225,000 that is subject to a $150,000 mortgage and a judicial lien of $50,000. The homestead exemption in Florida is unlimited, as long as the homestead meets the federal requirement that its equity was acquired at least 1,215 days before a bankruptcy filing (otherwise the exemption would be limited to $125,000.)
Cydney should consider paying off her $150,000 mortgage. By doing this, she will convert $150,000 of cash into an exempt asset--her home. She will be able to remove the $50,000 judicial lien attached to the property because this liens will be deemed to impair her homestead exemption.
The same strategy will be equally effective when the homestead exemption is limited, but the exemption amount exceeds the value of home.
Example
Wayne Oldham owns a home in Nevada valued at $300,000 that is subject to a mortgage in the amount of $200,000. In Nevada the exemption amount is capped at $550,000. By paying off the $200,000 mortgage, Oldham will convert cash to an exempt asset, while still ensuring he can eliminate judicial liens applied against his home.
Leverage consensual liens if home's value exceeds exemption amount
When the homestead exemption is limited and your home's value exceeds the exemption, you should keep the home encumbered with first or second mortgages. In fact, 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. If you follow this strategy, any judicial liens will be subject to elimination. Essentially, this practice makes the home judgment-proof, even though the homestead exemption is limited.
Example
Peter Piper has a Nevada home worth $750,000. The amount of the Nevada homestead exemption is $550,000. Therefore, $200,000 of the value of Piper's home in not protected by the homestead exemption.
Piper has 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, which means that the home can be foreclosed upon to satisfy that $100,000 judicial lien. And, for every dollar that Piper pays off on his the mortgage, another dollar becomes potentially available to a judgment creditor.
Instead of concentrating on paying off the mortgage, he should consider encumbering the home with a second mortgage, of at least $100,000. Then, the two mortgages would consume the full $200,000 of liens that can't be eliminated.
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, Piper would take a $100,000 loan from his holding entity, granting the holding entity a $100,000 mortgage in his residence.
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.
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.
