Loans to Adult Children Must be Addressed in Estate Planning

Mary and Thomas Charleton had five adult children. Unfortunately, not all of them had the means to purchase their own homes. So after each child married, the Charletons offered them a low interest loan to cover the down payment, up to a certain dollar amount.  All of the children took advantage of the offer.

Adult Children Loans

By the time Mary died—at age 62–three of the loans had been repaid in full. However, the couple’s daughter, Dory, made a partial repayment. When she got divorced after five years of marriage and was forced to sell that home, Dory decided she should no longer be required to repay the loan.  A son, Robert, figured the amount of the loan would just be taken out of his share of his parent’s estate.  He was fine with that.  He made no effort to repay the loan.

When Thomas died—at age 75—the family was surprised to learn that Thomas had long been teetering on the brink of bankruptcy and carried a large amount of debt.  Each child had signed a promissory note and the loans that remained unpaid were noted in Thomas’s will. During probate, the executor decided that the only way to pay off Thomas’ debt was to call the outstanding notes held by Dory and Robert. So the estate sued them to collect. Robert immediately paid what was owed, but Dory refused.

“None of the rest of us got a free ride, Dory,” said her older brother Marcus. “Why should you? Dad’s creditors have to be paid first, meaning we get nothing. You’re just going to have to cough up the money, because there is no way you are going to be the only one who benefits from Dad’s death.”

“You’re always looking for a free ride, Dory,” her sister Sara said. “It’s bad enough you’ve sponged off Mom and Dad your whole life. Time to pull up your big girl panties and pay up.”

When Dory continued to refuse to pay, the creditors filed suit to garnish her wages, as well as place a lien on her home.  If she sold her house, the creditors would have first crack at the proceeds. Her brothers and sisters refused to provide her with any financial assistance. In fact, as a group they decided to cut off all communications with Dory.

Unpaid loans are considered assets in estate planning and upon a testator’s death, it is the responsibility of the executor to collect the balance due. An estate cannot be settled until all loans are collected and all debts settled or paid. When an estate is insolvent, the collection of outstanding loans becomes especially important.  Creditors want to be paid and will pursue all available resources to accomplish that.

Many times, unpaid loans create dissension among heirs.  In some cases, heirs who owe money still expect to receive an equal share of an estate.  However, death does not automatically forgive a loan and when proper arrangements are made, the amount owed can and should be deducted from any inheritance due.

However, the issue of outstanding loans must be addressed in an estate plan. A list of all loan recipients, loan amounts, terms of the loan, and balances due should accompany a will or trust, along with instructions as to how the loan should be handled.  In some cases, it may be forgiven upon death or subtracted from an inheritance.  In other cases, immediate repayment may be required.  It is important to note that any provisions forgiving debt may not be honored by a Probate Court, especially if an estate is insolvent.

To ensure that outstanding loans to adult children are handled properly upon death:

  • Document all loans with properly executed, written promissory notes. A hug or a handshake is not sufficient to bind someone to loan repayment. Loans and repayment obligations should be spelled out in writing and include repayment terms upon the testator’s death.
  • Include language in your will or Living Trust about how the loan should be treated. Before making that decision, however, it is important to explore the tax ramifications of forgiving debt. If loans are not properly addressed, costly estate litigation or excessive taxation could result. Once a legal opinion has been sought, clearly explain expectations regarding repayment.
  • Consider estate distribution priorities. Creditor’s claims and costs related to the settlement of an estate take precedence over distributions to heirs. Spousal or domestic partner statutory or elective shares are second in line. When an estate is insolvent or diminished, debt forgiveness may be overlooked to satisfy those priorities. Quite simply, heirs cannot be enriched to the detriment of other preferred parties.
  • Keep it legal. Loaning children significant amounts of money prior to death and then forgiving that debt in estate planning documents, with the intent of defrauding creditors, is considered illegal. In that case, loan forgiveness is likely to be challenged and heirs may be forced to repay that debt to the estate.
  • Loaning money to relatives can create a difficult situation when other relatives are concerned. For that reason, it is important to discuss terms and conditions of a loan up front, and put that information in writing.