Losing a loved one is always a painful time. But what if that loved one was also deeply in debt? What happens to the debt? Do those left behind have to pay those debts off? Do they just disappear? Well, unfortunately the answer to that question is a rather complicated one. The problem is it largely depends on what state you live in, as the laws vary from state to state.
What Happens to Your Debt if You Pass Away: The Simple Answer
The most basic answer is when you pass away, what you own is stood against what you owe. So for example if you have $100,000 in assets, but $50,000 in debts, then $50,000 of those assets would go to pay off your debts and the other $50,000 would be split amongst the heirs in accordance with the provisions of the will. If there is no will, the money is distributed according to guidelines specific to your state.
If on the other hand, you had $200,000 in debt in that same estate, then that $100,000 would be split proportionately among the creditors. The heirs would not receive any inheritance but neither would they assume any responsibility for the remaining $100,000 of debt. That additional $100,000 is simply considered forgiven.
How Probate Court Will Process the Estate
Generally speaking, when you pass away your estate will be processed by your local probate court. In most states the court will follow the following steps in processing your estate.
Funeral expenses and attorney fees.
First, any funeral expenses are paid in full from whatever assets may be available in the estate. Additionally, any attorney or court fees accrued from the settlement of the estate are also paid before anything else is taken into account.
Next most states permit a family allowance to be paid to surviving spouses or minor children. The definition of this family allowance is defined by state law and varies greatly from state to state. In some states there is just a flat cap to this amount. Other states leave the amount more open-ended but the amount may be based on family need and in some cases is designed to provide needed support for a given period of time. You will need to discuss this with an estate planning attorney in your state, as these laws vary.
After a family allowance has been provided, then any debts are settled based on the amount of assets left and the amount of debt.
Once all debts have been settled, if there are still remaining assets, they are distributed to heirs in accordance with the provisions of the will. If there is no will then the estate is considered intestate. This means the probate court will distribute any remaining assets according to local state laws.
Exceptions to the Rule
That’s the general process most states follow. The problem is the rules governing this process are passed at the state level, and each state is a little different. Here are a few notable exceptions.
First, if there are any loans involved in the estate then these loans do not go away just because one party that signed on them is deceased. By definition, when you co-sign for a loan you are taking responsibility for paying that loan in full. If the person who was taking out the loan passes away then the bank will now expect you to repay the loan the same as if they had simply been delinquent on the loan. This is just one more reason why it is a really bad idea to cosign for a loan.
Let’s say grandpa had an antique car that he wished to pass along to his grandson. But grandpa also had several thousand dollars in debt, more than the liquid assets of the estate. The probate court will likely order the car to be sold so as to finish paying off the debts. If the grandson still wishes to inherit the car, then it may be necessary for him to assume responsibility for those remaining debts in order to avoid the sale of the car.
Community property states.
In most cases a debt that is in your name alone will not be passed to surviving family members. The major exception to this are the community property states: Alaska, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
These states passed laws that essentially stated any property acquired during a marriage, regardless of whose name is on the property, is considered community property. Unfortunately, this law also means that any debts acquired during the marriage, no matter whose name they are in, are also considered the responsibility of both spouses. Therefore if one spouse dies, all debts that were accrued during the marriage become the responsibility of the surviving spouse.
If you leave physical property (homes, cars, jewelry, etc.) to your heir and that property has debt, the debt will also be passed to the heir. For example, you pass away and leave your home to your child, but the home also has a mortgage associated with it. That debt will also pass with the property. The specifics of how that actually happens though depend on a number of variables. Depending on how the mortgage is written, the child may or may not be able to assume the mortgage. If the mortgage is not assumable, then it may be necessary for the child to refinance the home under their name. This could present a problem if the child has poor credit and cannot get a mortgage. Additionally, if the asset is upside down, in most cases the heir will only need to finance the property for the current value. There are many other scenarios and variables involved in this. If you are receiving property in an estate like this, it is advisable to seek the advice of a local estate planning attorney to make sure the ownership of the asset is properly transferred and debts are assumed in a way that follows the dictates of local state laws.
What Passes Outside of Probate
There are some things that generally pass outside of the probate process. These items do not have to stand against any debts that the estate may have. This includes items such as life insurance policies, 401K’s or IRA’s, pensions, or other retirement accounts. While these items are passed without being subject to debt, the beneficiary may need to use them if there are other items in the estate that pass to them with debt. In the previous example if the house is passed to the child with debt and the child is also a beneficiary on the life insurance, one option would be to use some of the proceeds of the insurance to pay off the mortgage.
Another topic that is outside the scope of this article are trusts. If assets of the deceased have been placed in a trust, the trust assets can also be passed on to the heirs outside the probate process. You would need to work with a good estate planning attorney in your area to understand the specifics of the trust.
Two Final Thoughts
First, if you don’t have a will, get one. Even if your estate is relatively simple and you have few heirs, having a will provides clarity and definition to a difficult time. Even if you don’t have much, you want to be the one deciding what happens to it and not the state.
Lastly, this article really just provides general guidelines. This can be a very complicated area and the rules can vary greatly from state to state. You need to seek the advice of a good estate planning attorney in your area to determine how the rules will be applied in your specific case.