Debts Owed to Deceased by Heirs and Beneficiaries in Estate Administration
One of the most common questions executors and trustees have about administration of trusts and estates is how to treat debts owed to the testator or grantor by heirs or beneficiaries. Parents often make loans to their adult children. Sometimes, these loans are unpaid when the parent dies. Unpaid loans of the deceased are assets of the estate to be collected by the executor or personal representative during estate administration.
Unpaid loans owed to the decedent can cause issues or complications in the administration of an estate. An issue arising with greater frequency is what happens if the estate is insolvent, meaning assets in the estate are insufficient to pay creditor claims and the costs of estate administration. Disputes among siblings arise frequently when one adult child expects to receive an equal inheritance to other heirs, despite failing to repay a loan made by the deceased parent. Whether it is a financially dependent adult child or a greedy sibling, these types of heirs are notorious for failing to accept that their inheritance may be reduced by the amount owed or the debt may need to be repaid.
Questions may also arise as to the deceased person's intentions regarding how an unpaid loan to an heir or beneficiary should be treated. For example, if there is a lack of clarity in the testator's will or the grantor's living trust regarding whether the loan should be forgiven at death, it may open the door for a legal dispute.
Laws Applicable to Probate and Estate Administration Vary by State
The laws governing debt forgiveness by a testator and unpaid loans owed to an estate are set by individual states, in state probate codes and common law. Consult a probate lawyer for guidance on applicable state law.
To learn more about the treatment of debts owed to the deceased by heirs and beneficiaries, see The Complete Book of Wills, Estates & Trusts, Third Edition. Authored by the highly regarded estate planning attorney, Alexander A. Bove, Jr., this book covers the essentials of estate planning, probate, and estate administration. He writes about this often mundane subject with unparalleled humor and wit.
Debts Owed to Testator May Reduce Heir's Inheritance
To the extent an heir has failed to repay a loan made by the testator, the unpaid amount may be used to reduce any inheritance the heir would otherwise receive from the estate. To the extent an heir or beneficiary wishes to dispute this, such as on the grounds that the loan was repaid or the deceased expressly forgave the debt prior to death, he or she should consult a probate lawyer.
Testator May Forgive a Debt in Last Will and Testament
To the extent a person wishes to forgive a debt that has not been repaid at the time of his passing, he or she may do so by making a will and including language in the will regarding how the debt should be treated. This type of debt forgiveness is typically honored, provided the estate's assets are adequate to pay all creditor claims, taxes, expenses of administration, and other financial obligations of the estate.
If the debt is evidenced by a promissory note, mortgage, or other written document, the testator may wish to include language regarding debt forgiveness in that document as well. Failure to do so could result in the heir or beneficiary being required to pay back the debt after the testator's death. Any attempt to discharge a debt in a testamentary document or other legal instrument should be handled by an attorney. If done incorrectly, the provisions regarding loan forgiveness could result in a costly legal dispute. Debt forgiveness can also have gift tax ramifications, so expert legal advice is essential.
Clarify How You Want Outstanding Loans Treated by Your Estate
If you loaned money to someone who may inherit from your estate or receive a distribution from your living trust, it is important to clarify whether you want this loan forgiven when you die or want the unpaid amount to reduce any inheritance the heir or beneficiary will receive. This is especially important if you want to ensure your children, grandchildren or other heirs inherit equal shares of your estate. For information on how to handle this in your estate planning documents, consult an attorney. If you are preparing your own will or living trust, see Quicken Willmaker Plus 2012 Edition: Book & Software Kit.
Note, if you live in a community property state, the loan may be community property in which your spouse or domestic partner owns an interest.
Debt Forgiveness May Not Be Honored If Estate is Insolvent
A testator may include a provision in his will or living trust to forgive debts owed by an heir or beneficiary at the time of death. If, however, the deceased left a mountain of unpaid debts, the testator's debt forgiveness may not be honored. An overriding principle of estate administration is that creditor claims and costs of settling the estate must be paid before any distributions may be made to heirs and beneficiaries. Any statutory share or elective share of a spouse or domestic partner may also need to be paid before an unpaid loan can be forgiven. A testator cannot enrich his children or other heirs to the detriment of his creditors by advancing money to heirs and including debt forgiveness provisions in a testamentary document.
If the debt is evidenced by a written document, such as a promissory note, a court may also use the provisions of that document to determine whether the remaining balance of the loan must repaid to the estate. One of the most recent cases to consider this issue is Bernadette Lauritsen, as Personal Representative of the Estate of William C. Wallace v. Brian A. Wallace, 5th DCA, Case No. 5D10-1020, April 1, 2011.
. Authored by the highly regarded estate planning attorney, Alexander A. Bove, Jr., this book covers the essentials of estate planning, probate, and estate administration. He writes about this often mundane subject with unparalleled humor and wit.
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Note, if you live in a community property state, the loan may be community property in which your spouse or domestic partner owns an interest.