Protecting Out-of-State Real Estate from Only One Spouse’s Creditors in Bankruptcy

In Michigan, if a husband and wife jointly own real estate, an unlimited amount of equity in it can be fully protected from the creditors of only one spouse.  This type of joint ownership is known as “tenancy by the entireties” and this type of property is known as “entireties property.”   The protection to entireties property is available whether or not the couple files bankruptcy.[1]  But, it is limited if the couple has joint debt.  Then, the amount of equity that can be protected is reduced by the joint debt.

To illustrate, consider a couple that owns a home worth $1 Million subject to a $300,000 mortgage, and jointly owe $25,000 on various credit cards; while only the husband owes $1.5 million to a business creditor.  In this case, the couple could shield $675,000 of the $700,000 of equity in their home from the husband’s creditors.  In other words, the husband’s $1.5 million creditor could, at best, only collect $25,000 from the equity in the couple’s home.

This protection would also cover an unlimited amount of additional real estate jointly owned by a husband and wife--like a second home in Michigan and in 12 other states that also recognize entireties property.[2] If our couple, however, jointly owns or is about to purchase real estate in one of those other 37 states, they may still be able to take advantage of the protections to entireties property.  The best way would be by transferring title to the real estate from the couple to an entity, or purchasing it through an entity in the first place.   Now, the couple, through that entity, would have an indirect interest in the property.

So, what type of entity should our couple select to own property in one of those 37 other states? These days, generally, limited liability companies (LLC) are preferred over corporations because LLCs not only provide limited liability to their owners, centralized management, continuity of life and free transferability of ownership, they also provide tremendous flexibility as to how their members (owners) are taxed.  Yet, if the primary reason for placing title of the real estate in an entity is to protect it from the creditors of only one spouse, then a corporation is a better choice of entity.

To understand why,  a closer look at  MCL §557.151 is necessary.  It lists various types of non-real estate that can be owned as entireties property, and includes stock certificates and bonds owned jointly by a husband and wife. While MCL §557.71 protects all entireties property from the creditors of only one spouse.  Unfortunately, the list in MCL §557.151 does not include membership interests in an LLC.   This silence is not at all surprising since MCL §557.151 was enacted in 1927 and has not been amended since. In contrast, Michigan first recognized LLCs only relatively recently, in 1993.[3]

Since LLCs did not exist when MCL §557.151 was enacted, perhaps courts would extend this statute to include membership interest in LLCs since the vast majority of new entities formed today are LLCs rather than corporations.  However, no court has had to decide this issue yet. So, if a bankruptcy court confronted with this issue decides not to extend MCL §557.151 in this manner, the consequences could be severe.  In that case, the membership interests in the LLC would be part of the debtors’ estate and the chapter 7 bankruptcy trustee could then take control of the LLC and sell the real estate.[4]  

In our example above, if the husband filed bankruptcy, then the chapter 7 trustee would sell the couple’s home and keep $375,000 instead of only $25,000 for distribution to their creditors.[5]  This risk may be avoided by simply placing ownership of the real estate into a corporation.

A final word of caution is warranted.  If the couple transfers the real estate to the corporation within 6 years of their bankruptcy filing, the transfer may be challenged under other sections of the bankruptcy code.  The scope of these challenges is beyond the scope of this article, but will be addressed in a future one.