What is Exemption Planning?
Exemption planning is the process of reorganizing one’s wealth so that much of it is protected (or “exempt”) by law from creditor attachment, even though it's still owned by that individual. There are some asset types exempt under federal law, but most exemptions come from state law. Then there are bankruptcy exemptions, which may use federal and/or state exemptions, and which only apply in bankruptcy. The types of state-protected assets vary greatly from state to state. Furthermore, the extent to which assets are protected in a given state also varies. However, there are general categories of exempt assets. These categories include:
- A single personal residence (commonly referred to as a “homestead”).
- Pension and retirement plans, which may be protected by state and/or federal law.)
- Life insurance.
- Items necessary for daily living, such as furniture, an automobile, and clothing (these items are usually only exempt to a few thousand dollars or less).
- Wages (only protected by a few states, but somewhat protected federally, as the section on wage exemptions discusses below.)
At first glance, you would think exemption planning to be simple. After all, if the law says an asset is exempt, then it’s exempt, right? Not always. There are always exceptions, caveats, and conditions to the exemption laws. Knowing when an “exempt” asset is truly exempt from a certain creditor and when it is not is what separates the best asset protection planners from the mediocre masses.
The homestead exemption is a state law (or, sometimes, part of the state’s constitution) that is designed to at least partially protect one’s home from creditors. It is important to read the fine print in a given state’s exemption law. For example, the Texas homestead exemption, which is touted by many, along with Florida’s homestead exemption, as one of the best in the nation, still provides statutory exceptions as to when the exemption does not apply. The law says, for example, that the exemption does not protect against:
- Property taxes.
- Liens arising due to an initial loan on the home, a refinancing loan, a reverse mortgage, or an equity line of credit.
- Mechanic’s liens.
- Partition in the property as a result of divorce.
What’s more, many exemptions only protect a limited amount of equity in certain assets. For example, although Iowa, Florida, Texas, Kansas, and Oklahoma protect 100% of one’s homestead from creditors, North Carolina only protects $18,500 of a homestead’s equity. Therefore, if one owned a North Carolina home having $300,000 net equity, a judgment creditor could foreclose on the home and seize any sales proceeds that are not covered by pre-existing liens or this limited exemption. Other than the states mentioned, a few states will not protect any home’s equity, and other states protect varying amounts of equity.
The good news is that homestead protection is added on top of whatever mortgage secures a home. For example, if a home is worth $600,000, but it has a mortgage for $500,000 and is located in a state with a $50,000 homestead exemption, then only $50,000 of the home’s value is exposed to creditors. This is because the mortgage is a lien that is secured specifically to the lien holder. It is there to ensure that the lien holder’s debt or other obligation is repaid. Thus, the equity covered by a mortgage or other lien is unavailable to unsecured creditors (i.e. a creditor that does not have a lien on the property), or to secured creditors whose lien arose afterwards.
Some individuals use mortgages or other types of liens specifically to protect their home from other creditors. We call this technique equity stripping and this book examines such in Chapter 15. Because the homestead protection and pre-existing liens are added together when calculating how much equity is available to subsequent creditors, some homesteads are mostly or completely protected even in states that don’t offer complete homestead protection. At the same time, as a mortgage gets paid down or the property appreciates in value, more and more equity becomes exposed. It is dangerous to therefore think that justbecause a home’s equity is currently covered by a limited homestead exemption that it will always be covered.
With that said, merely using a home as one’s primary residence does not always mean that home is protected by homestead laws. Some states have additional requirements one must meet to claim homestead protection. Some states require their residents to file a declaration of homestead in a public office. Other statesimpose a short residency period before they grant homestead protection. In certain states, only the head of the household can claim homestead protection; however, most states allow either spouse to do so. If you are married, be careful. Sometimes when both spouses file homestead declarations, their cross-declarations cancel each other out.
There are other potential traps. For instance, in Florida, you may or may not lose your homestead protection if you title your home to a trust. Tens of thousands of Floridians have been advised by their estate planners to title their home to their living trust to avoid probate, not realizing that doing so may make them lose their homestead protection. Unfortunately, few of these people realize their homes may now be lost to creditors.
Bankruptcy Exemptions/Pre-Bankruptcy Planning
Up to this point, we’ve mostly discussed exemption planning in a non-bankruptcy context. However, when one files for bankruptcy the exemption rules change considerably. Therefore, when doing exemption planning one must consider the likelihood of an individual declaring bankruptcy in the future. Even if bankruptcy is unlikely, one must plan for the contingency that it could happen. For example, an individual could be involuntarily petitioned into bankruptcy (Chapters 7 or 11) by three or more creditors if their aggregate claim exceeds $12,300, or even by one creditor if the debtor has fewer than 12 unsecured creditors, and the creditor filing the petition has claims exceeding, in the aggregate, $12,300.
The law of the state where one resides determines whether one may use state exemptions only, or whether one may choose between state or federal exemptions. If a state allows one to choose, then one may choose one set of exemptions but not both. The federal exemption amount may be doubled for a married couple, although this may or may not be the case with state exemptions.
Note that moving to a more exemption-friendly state before one files bankruptcy only works if the move is made at least 730 days (about 2 years) before filing.If state exemptions are chosen, there may be federal restrictions to those exemptions. The most notable is the homestead restriction. Federal law states that a homestead exemption may not exceed $125,000 for any home purchased within 1215 days (3.3 years) of filing bankruptcy (the full homestead exemption is allowed so long as one owns their home for more than 1215 days before filing.)
(From Asset Protection in Financially Unsafe Times, p. 73-75, 82-83