Protect Your Home

As personal finance advisers to numerous physician clients, we are constantly amazed at how few physicians have shielded their homes from lawsuits. Doctors pay millions of dollars over their careers for medical malpractice insurance coverage and often thousands more to protect some of their assets, yet they still fail to protect their single largest asset. Why is this?

Perhaps you believe that your home is protected from creditors by your state Homestead Act. Or maybe you think your home is protected from a judgment against you because you put it in your spouse's name, or through "tenancy by the entirety" statutes. Don't bet on it: such "protections" are typically weak at best. Or you might be gambling because you think protecting your home means incurring expensive legal costs. Wrong again.

What if you learned that you could shield your home and build asset-protected wealth for retirement at the same time? Wouldn't you consider it? If you learned that both could be done quickly, simply, and with very little expense, wouldn't you kick yourself for not doing it sooner?

What Vance did

Consider the case of Vance, a gynecologist from North Carolina:

He owned a home worth $635,000 with a mortgage of about $350,000. His monthly mortgage payment was almost $3,000, of which $1,300 was interest. He was in a 46 percent marginal tax bracket, when state and federal income taxes, payroll taxes, Social Security, etc., were factored in. As a result, there was a tax savings of $600 on his mortgage, leaving him with a net after-tax monthly mortgage payment of $2,400.

Vance wanted to protect his home and investments from lawsuits, reduce his annual expenses, and protect his family from an unexpected death. He also liked the idea of building wealth without having to see more patients or take more call. 

Using a mortgage company we recommended to him, Vance refinanced his home - taking out an interest-only loan for the full $635,000 value. This loan was used to repay the existing loans from his local bank. After repaying the bank, he had $284,000 left in cash and he had zero equity in his home - thus making his home worth nothing to future lawsuit claimants. The new pretax mortgage payment was $2,858 - all interest, since he now had an interest-only loan.

Factoring in his 46 percent tax rate - we worked with Vance's CPA to structure the interest on his new mortgage as deductible - Vance enjoyed a tax savings of $1,314 each month on the mortgage. Thus, the new after-tax monthly mortgage cost was only $1,544. This was a savings of $850 per month. 

Next, Vance had his attorney establish a special-allocation, asset protection limited liability company (LLC) to protect his brokerage accounts - and the new $284,000 he had to invest. The LLC, which cost less than $5,000 to create, then invested part of the $284,000 into a cash-value life insurance policy - in his case, he chose an equity-indexed life insurance policy that grows at the same rate as the S&P 500, subject to a 1 percent minimum and 17 percent maximum annual return. The policy projects to have more than $1 million of cash value after 15 years of growth, assuming the mean S&P stays at its historical mean rate of return of 9 percent.

Vance's new mortgage payment is now $850 per month lower than his previous mortgage ($10,200 per year after-tax savings). His home equity is now protected since he has no exposed equity. The market value of the house is growing at the same rate as it was before. Even better, Vance has $284,000 invested in a cash-value life insurance policy that figures to be worth $1 million in 15 years. In fact, the policy projects tax-free income of over $100,000 per year from age 68 through age 100. This is in addition to the extra $10,200 of spending he has each year!

Jealous? You don't have to be. You can develop the same kind of asset-protecting, wealth-building plan that Vance did, and you should.

What experts know

But wait a minute, you say. The key to Vance's strategy was refinancing his home, taking out an interest-only loan. That means Vance isn't building equity in his home. Is that really a good idea?

For people in high tax brackets, including many doctors, it sure is.

To understand why, you first have to realize that the long-held notion that equity equals wealth is a myth. Real estate professionals know better. In fact, they think of equity as a cost; they call it the "opportunity cost."

If Vance's situation doesn't convince you, maybe the following comparison will:

• Dr. Smith, a neurologist in New Jersey, purchased a home for $500,000. He made a down payment of $100,000. His mortgage amortizes over 15 years and he plans to pay interest and principal until the home is paid off completely. Assume that, after five years, the value of Dr. Smith's home has increased to $700,000 and he has paid down the mortgage from $400,000 to $300,000. If Dr. Smith sells, he will net $300,000 pre-tax.
• In California, an ophthalmologist named Dr. Jones purchased a home for the same price. Let's assume he did so at the same time with the same increase in market value over five years. But Dr. Jones has an interest-only mortgage. Rather than pay down the $100,000 on loan principal over the first five years as Dr. Smith did, Dr. Jones invested his $100,000 and gained 8 percent on this investment. At 8 percent, it grew to over $147,000 at the end of year five. If Dr. Jones sells both the home and the investment, he would net $347,000 pre-tax. By choosing to invest his extra capital rather than "build" equity like Dr. Smith, Dr. Jones increased his wealth by 16 percent more over only five years - without any more work.

Why did Dr. Jones create more wealth than Dr. Smith? Because Dr. Jones realized that paying down the equity of the home did not increase his wealth as much as investing in a better opportunity. In other words, there was an "opportunity cost" for Dr. Smith to use his $100,000 (over five years of principal payments) when a superior investment was available.

This strategy is called the "debt shield," not because it shields you against debt but because it allows you to use your own debt as a shield against lawsuits and taxes, while using the cash you get up front to invest in protected assets.

Borrowing against your home for this purpose makes even more sense when you consider the tremendous tax incentive: since the interest on real estate loans is usually tax-deductible, the after-tax cost of the loan can be very low.

This idea that you should invest your funds rather than pay down home equity is so clear for high-income taxpayers that Forbes magazine recently endorsed it. ("Hock Your House," Dec. 13, 2004). 

How to do it

The strategy is quite simple. It involves you, your home, and a mortgage company. Depending on your state, it may either involve a life insurance policy, annuity, and/or specially-designed LLC. The two basic steps of the debt shield strategy are as follows:

• Protect 100 percent of the home equity with the mortgage. Through either a refinancing or home equity loan, the mortgage company loans you money. You pay off existing lenders and invest the proceeds into some asset-protected vehicle (see step 2). This protects the home equity (since there is no longer any equity) against future claims via the mortgage (the security interest). 
• Invest the loan proceeds in an asset-protected investment or entity. As is the case with all asset protection planning, the key to the debt shield strategy is efficiently moving wealth from unprotected to protected title. The loan proceeds must be invested in a strong asset-protection tool - or there will be no protection. Ideally, you would want to invest the loan proceeds in a totally exempt asset such as life insurance and, in certain states, annuities. If your state does not protect these assets from creditor by statute, we will help you create a specifically designed LLC to own the investments. This will protect the home equity without disqualifying you from using tax-favored investments.

Typically, we use cash-value life insurance as the investment vehicle in the debt shield structure. This is also the case when we have to utilize an LLC or FLP to provide the investment an acceptable level of creditor protection. Many doctors fail to understand why life insurance is the ideal investment for high-net-worth and high-income investors. We recommend life insurance because:

• Life insurance policies offer guaranteed minimum returns. Many policies guarantee minimum annual crediting rates of the invested cash values at 3 percent or 4 percent per year. This may be even with (or even greater than) the after-tax cost of the loan interest - allowing you to lock in an upside arbitrage.
• Life insurance policies offer upside while protecting your downside. We see many clients invest in an equity-indexed universal life policy that credits the same return as the S&P 500 index, as did the physician in our real-life case study above. 
• The growth life in a life insurance policy is tax-deferred, and withdrawals and policy loans from a life insurance policy can be taken tax-free.
• You can access the cash values in life insurance policies completely tax-free - even through the LLC - at any time.

If you have any existing life insurance in place before you implement the debt shield strategy, you may decide to stop paying on the existing policies and further improve your monthly cash flow. This increases the upside of this strategy.

For most physician families, there is no more important asset than the home. If you would like to protect your home while building wealth without working any harder, you owe it to yourself to explore the enhanced debt shield strategy.

David B. Mandell, JD, MBA, is an attorney, lecturer, and author of the books The Doctor's Wealth Protection Guide and Wealth Protection, MD. He is also a cofounder of The Wealth Protection Alliance (WPA), a nationwide network of elite independent financial advisory firms whose goal is to help physicians build and preserve their wealth.

Brian H. Breuel, JD, CLU, ChFC, CFP, is the author of the book Staying Wealthy: Strategies for Protecting Your Assets, and is a charter member of the WPA. Both Brian and David can be reached via info@wealthprotectionalliance.com, (800) 554-7233, or at editor@physicianspractice.com.

This article originally appeared in the May 2005 issue of Physicians Practice.