Protecting Your Equity from Lawsuits

In today’s lawsuit-happy society, investors are anxious to protect their assets from litigation. As a result, there are many professionals in the business of helping investors meet this need. But consumers need to be very careful about the advice they receive and the path they choose.

A recent reader’s question illustrates this point perfectly. He and his siblings own a debt-free commercial property and this is his story:

“My brother was told by someone he implicitly trusts that mortgage-free properties are “sitting ducks” for liens resulting from lawsuits; that unless we “borrow” [most of the equity] we could very well lose the entire property to “thieves” looking for mortgage-free or low-mortgage properties. Our adult son is currently going through a non-related legal battle that has cost him [tens of thousands of dollars] so far. If his case goes to trial and should he LOSE this trial, my siblings and I are being told we very well could LOSE our co-owned property. Is that true?”

I can sure understand the reader’s concern. Either the ‘implicitly trusted’ person didn’t understand the situation, or the brother didn’t understand what that person said.

There are two issues that need to be addressed in this situation. First, the risk to the siblings’ equity in this property due to lawsuits, etc. Second, whether borrowing all the equity is the proper way to mitigate that risk.

We live in a very litigious society and anyone can sue someone else for just about any reason. That doesn’t mean they will be successful. There has to be fault. For instance, if one of the siblings above killed someone in a car wreck then he/she will probably be sued. Any assets he/she owned can be targeted. If the ownership in the above property is tenancy in common then the portion owned by the other siblings is not at risk. If, however, the property is owned via joint tenants, meaning that they all own the property jointly, then the whole property would be at risk.

But what about the legal troubles of our reader’s adult son? Does that put this property at risk? No, it doesn’t. If the son doesn’t have any ownership in the property then it is not an asset that can be pursued by the other party. Even though the son may be the beneficiary, he doesn’t own it until his father dies.

So it is true that assets like real estate equity, as well as stocks, bonds, and mutual funds can be subject to loss in a lawsuit, but only where an asset holder is at fault. To reduce that risk, I’m not sure borrowing out the equity is the best solution.

Borrowing the equity is just going to transfer the asset from one place to another. If one borrows against the building, they have to put that money somewhere else. Usually, it will be exposed in the new place as well.

The risk of loss can be reduced through insurance. There is liability insurance that can be used, but the protection isn’t complete.

The most secure method, in my mind, of protecting someone’s assets is for them to be owned by an irrevocable trust. An irrevocable trust protects the assets from the claims of creditors.

An irrevocable trust protects its contents from outside threats, but not from inside threats. Think of it as a bubble. The trust bubble protects what’s inside from being affected by a lawsuit arising from something outside the bubble—like an automobile accident. On the other hand, if a rental property is in the trust bubble, that rental property is exposed to lawsuits dealing with that property. If someone slips and fall on the property and sues, that property can be lost.

That’s why it is recommended that there be separate irrevocable trusts for each property. That way, each is isolated from the risks associated with the others.

Of course, you can see that this can become very involved. That’s why not too many people do it. Also, irrevocable trusts can’t be changed so it’s very important that they be set up correctly.

The bottom line is that even though real estate equity may be at risk to a lawsuit, borrowing the equity to invest in something else doesn’t seem to me to be the best remedy.

Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at www.guardingyourwealth.com.