Granting Security Interest (Lien) On Non-Exempt Asset In Favor Of A Friendly Creditor
Sometimes people who owe large amounts of debt to mortgage lenders, commercial banks, and credit card companies also owe money to family members. These debtors have borrowed significant amounts of money from family, or in some cases good friends, in their attempt to pay their monthly payments and avoid default and lawsuits. Some of these debtors have maintained valuable assets free and clear of any lender security interests. Some debtors own free and clear real property; others have significant securities accounts which are vulnerable to a judgment creditor.
I often meet with clients who suggest that they transfer free and clear assets to family creditors in repayment of the loan. This preferential repayment of the family accomplishes two goals. The repayment transfers a non-exempt vulnerable asset out of the debtor’s name and also repays the family member to whom the debtor feels a moral obligation to pay back before exposing non-exempt assets to general judgment creditors.
Although repayment of a legitimate family loan in advance of a lawsuit is a defensible plan, I usually recommend a variation of this strategy. For several reason I think it better for a debtor anticipating litigation to pledge his non-exempt assets as security for a friendly loan rather than transfer title to the friendly creditor. Here are two examples of why I usually prefer granting a security interest rather than title transfer in full satisfaction of a friendly debt.
A transfer of title to the friendly creditor invites challenges regarding the asset valuation. A creditor is likely to contend that the asset was worth significantly more than the loan. Even if the debtor has the asset appraised for an amount less than or equal to the loan the true value is a factual issue, the judge’s valuation is not predictable. Also, transferring ownership appears, in my opinion, to more likely come under the definition of a “fraudulent transfer” rather than retaining ownership subject to a new security interest. Second, if the debtor’s non-exempt asset has appreciated in value the conveyance to the friendly creditor could trigger income tax on the amount of gain because the transfer will be deemed a sale. Granting a security interest in the same asset is not a taxable sale.
