What You Should Know About Protecting a Home from Creditors in Arizona
1. How does the Homestead Exemption protect a primary residence?
In Arizona, a primary residence qualifies for a homestead exemption. The exemption protects up to $150,000 of equity from creditors (excluding mortgage lenders). Although homeowners qualify for this benefit automatically, the exemption requires filing for bankruptcy in order to claim it and protect the equity in a home. This is a strategy most homeowners prefer to avoid.
The Arizona homestead exemption conflicts with federal bankruptcy law, which limits the exemption in bankruptcy to $125,000. When this issue was litigated in 2005, the bankruptcy court ruled that the exemption amount for Arizona residents is limited to $125,000 if the personal residence was acquired less than 1,215 days before filing.
2. Does a Revocable Living Trust protect the primary residence?
No. A revocable living trust does not provide any protection from creditors. The general rule is that a creditor can seize any trust asset that its original owner could too. The trustor of a revocable living trust has full access to its assets, and thus, a creditor does too.
3. What if parent gifts the primary residence to a child?
Many people assume the best way to protect a home from creditors is to gift the property to a child. This strategy
has major drawbacks. First, the transfer is a taxable gift and must be reported to the IRS. Second, the transfer must be unconditional and irrevocable. In other words, the child is under no obligation to cooperate with the parent and could refuse to give it back. Third, the property keeps its original cost basis, even when the parent dies. This may cause higher taxes upon sale of the property after the parent dies. Fourth, the parent’s home could now be lost completely if a creditor wins a judgment against the child (homestead exemption is lost).
4. What if one spouse transfers the residence to a lower risk spouse?
It may be possible to have one spouse disclaim all ownership rights to the residence. For example, husband/physician transfers all ownership rights to housewife. In Arizona, this might work, provided all payments for the property are paid out of the husband/physician’s separate funds. Otherwise, a creditor would argue the residence is community property, even though the husband/physician’s name is not on the deed. This strategy also has two major drawbacks: (1) if husband and wife divorce, the wife keeps the property, and (2) wife could get sued (perhaps as a result of a car accident).
5. What if the residence is transferred to a Limited Liability Company?
Although placing a rental property or vacation home into a LLC often makes good sense, it does not make sense to place a primary residence into a LLC for several reasons:
- Disqualifies property for $250,000 exclusion of gain upon sale of property under Code Section 121.
- Possible loss of income tax deductions for property taxes and mortgage interest.
- Possible loss of homestead exemption.
- Homeowner's insurance premiums likely to increase.
- Possible increase in property taxes.
- A single member LLC provides little, if any, protection of the LLC assets.
6. What about transferring the residence into an irrevocable trust?
One option is to place the primary residence into a Qualified Personal Residence Trust. This is a type of irrevocable trust often used to minimize estate taxes. The typical QPRT irrevocably transfers future ownership rights to children, while giving the parents a right to occupy the residence for a term of years. Since the parents are restricting their ownership rights, a creditor of the parents should not able to seize the children’s ownership rights. There is precedent, however, for a determined creditor to seize control of the property until the original term of years expires. Thus, a QPRT is not a highly effective creditor protection tool.
A second option is to transfer the primary residence into a domestic asset protection trust. Since a DAPT is disregarded for income tax purposes, this option avoids some of the drawbacks of other options. The major drawback of a DAPT is that it must be managed by an independent Trustee in a state providing creditor protection to its DAPTs (not Arizona). This adds management costs and means a loss of control to the owners.
7. So what is the best option for protecting a primary residence?
There is no clear answer to what is the best option for protecting a personal residence. In general, a home is better protected from creditors when its equity is very low (at least under $125,000 in Arizona). This strategy may work effectively, especially when combined with adequate liability insurance and an umbrella liability insurance policy. Of course, the best option of all – from an asset protection standpoint at least – is to rent!
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
Thomas J. Bouman, Attorney
Bouman Law Firm
7650 E. Broadway Blvd. #108
Tucson, AZ 85710
(520) 546-3558
