- A home with no mortgage is like a car without a motor – it can do no work.
- By mortgaging a home or homes, you significantly increase the level of asset protection.
- Owning a home or homes outright presents physicians with a variety of financial risks.
- The value of a home can be dormant, or it can be working for the homeowner.
- By borrowing against your home and securely investing the assets, your home is earning money for you rather than costing you money, and is highly asset protected.
Protect Your Home
A physician who owns two homes outright, say a primary residence worth $350,000, and a vacation home that is conservatively worth $1 million, would usually be very proud of her financial acumen.
In fact, this physician is in position in which two very valuable assets are fully exposed to litigation risk. As well, this $1.35 million is not doing anything – it’s stationary, immobile. A million dollars is a lot of money and most shrewd investors could make a lot of money with $1.35 million.
So why leave $1.35 million lazing about in your real estate portfolio? That’s a $1.35 million economic engine that could be powering your practice, your business, your philanthropy, and your personal finances.
Mortgaging a Home Has Many Benefits
Essentially, when you borrow and invest the value of your home, you are leveraging it. In finance this means that you are using an the power of money -- yours or someone else''s -- to make money for yourself.
While having someone else – a bank for instance– own your home is counter intuitive to the majority of investors, it can actually provide a number of benefits:
- The value of the real estate can be freed and used to make investments that pay a return.
- The interest on the mortgage of a first and second home is both historically low and is 100% deductible from your taxes; It costs you nothing to borrow this money.
- However, you can turn around and invest the money you’ve borrowed on your home and invest it in cash value life insurance, annuities, a wide variety of trusts, more real estate, bonds, and other very-low risk investments that pay more than the tax-deductible interest on your mortgage or mortgages.
- You could use the money to finance a pharmacy or laboratory that becomes part of your practice, to market your practice, or to otherwise improve your business.
- The important point is that by borrowing against your home and securely investing the money, your home is earning money for you rather than costing you money, and is entirely asset protected.
- There are many other safe ways to use the equity in your home to earn money for you, your family, and your practice. Discuss these options with your financial advisor.
Risk
One might think that financial risk is a primary reason to pay for a home in cash or to pay down a mortgage quickly. The investor thinks, “My homes are owned outright so they are not at risk.” Well, the accuracy of this statement depends entirely on the type of risk being considered. If foreclosure is on your mind, the risk is probably quite low.
On the other hand, if you’re concerned about losing the value in the home or homes to market risk, in a divorce settlement, or in a lawsuit judgement related to your medical practice, then you are quite right to be concerned.
Millions of homeowners lost their homes due to market volatility around the 2008 recession. However, it is important to remember that these people lost money because they were forced to sell. If they had not been forced to sell, they could have held those properties until today when they are frequently exceeding the 2008 values (depending on the market).
Certainly many physicians have lost a home because of divorce, a professional lawsuit in excess of malpractice coverage, or through a lawsuit brought by a disgruntled or injured employee that was not covered by insurance.
Indeed, if you own your homes outright, they are maximally exposed to lawsuit and a wide variety of litigation risks and the home or homes can be taken from you by governments, courts, and individuals in order to satisfy all sorts of debts under a variety of circumstances.
A fully mortgaged home is exposed to none of these risks because you don’t own it.
Other Ways to Protect Your Home
There are a handful of ways that you can fully protect the value of your home. In some cases these techniques must be combined, but there are ways to eliminate nearly all of the risks to first and second homes.
There are a number of strategies for protecting the home, each with pros and cons. State homestead laws, tenancy by the entirety (TBE), limited liability companies (LLCs), limited family partnerships (FLPs), and the debt shield are some of the most common strategies.
State Homestead Law
Every U.S. state has some type of homestead protection law. In most states, such as New Jersey, New York, and California, the level of protection is very low when compared with actual market value of the real estate. In New Jersey, for instance, it is $0. In New York State, the homeowner is afforded $100,000 in protection. In California the amount of homestead protection ranges from $50 to $100,000, depending on a variety of circumstances. On average, state homestead law protection ranges between about $30,000 and $50,000 of equity. These levels are typically much lower than the amount of equity an established physician might have in his or her home.
Tenancy by the Entirety
Tenancy by the entirety, a form of joint ownership available in a number of states, is a viable option for clients of those states, which include Alaska, Arkansas, Delaware, Florida, Hawaii, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, Wyoming, and the District of Columbia. In these states, the TBE homestead protection on the sliding scale falls between +1 and +3, depending on the state and its court interpretations.
Inherent in TBE, are a number of risks including the following:
- Joint risk. Tenancy by the entirety provides no shield against lawsuits that potentially arise from jointly owned real estate.
- Divorce risk. If you rely on TBE for protection and you get divorced before or during the lawsuit, you lose all protections from TBE.
- Liability risk. If you rely on TBE for protection and one spouse dies before or during the lawsuit, you lose all protections from TBE.
- Death risk. Tenancy by the entirety is a less effective ownership form for estate-planning purposes because, at the death of the first spouse, the entire value of the home will automatically be entered into the surviving spouse’s taxable estate.
For these reasons, TBE alone is generally not sufficient protection. Savvy investors generally combine TBE with the debt shield technique.
Limited Liability Companies and Limited Partnerships
Limited liability companies (LLCs) and limited partnerships (LPs) are two tools that can protect a primary residence. Many financial advisors recommend these techniques for this very purpose.
The drawbacks of these methods are good examples of why it is beneficial to physicians – especially those in private practice – to work with a multidisciplinary financial planning team.
When it comes to the primary residence, LLCs and LPs entities are not sensible choices. Unlike other assets, the family home has unique tax attributes—most notably, the deductibility of mortgage interest and the $250,000 per-person ($500,000 per couple) capital-gains tax exemption. By owning the home within an LLC or a FP, both of these tax benefits are lost, unless only one spouse owns 100% of the interests in the LLC or FP, in general.
The bottom line is that LLCs and LPs can no longer be trusted to protect the family residence or residences.
Qualified Personal Residence Trusts
When using a qualified personal residence trust (QPRT), the owner transfers ownership of the home to the QPRT irrevocably. While this is certainly effective for both asset-protection and estate-planning purposes, it comes with a significant cost: You no longer own your home. In fact, when the term of years is up (typically 10 years), you have to pay fair-market value rent to the trust in order to live in the home.
Homes with mortgages present further tax difficulties. For these reasons, while the QPRT is a strong asset-protection tool, it is typically not appropriate for younger physicians whose main concern is asset protection instead of estate planning. Nonetheless, if it can be implemented correctly, a QPRT receives a rating of +4 or +5 on the sliding scale of protection.
Again, the fully mortgaged home may be both the most financially productive, and best protected home. If you have questions about your personal or professional finances, Ask Mike, Michael Berry, the lead financial advisor for MDalert.com. You can reach him at mberry@msf-advisors.com.
