Estates 101: Insolvency

You’ve added up all the numbers.  Probably three times, because you were horrified the first two times.  But no matter how you slice it, the estate’s assets just won’t pay all the debts.  The estate is referred to as “insolvent”.

What do you do?

Priority of debts.  Suppose the estate has $10,000 in assets and $20,000 in debts.  You’ll pay the $10,000 out until the estate is empty and tell everyone else they lose; but who gets paid and who loses?  It is not up to the representative. The law assigns a priority.

In Pennsylvania the priority list is:

  1. Estate administration costs (filing fees, legal fees, accounting fees, and compensation for the personal representative).
  2. The family exemption.  The surviving spouse, or the deceased’s children or parents living in the same household, are entitled to a payment of up to $3500 divided among them (in cash or property value).  (I didn’t live with my mom, she was divorced, and her parents died years ago, so this didn’t apply in our case.)
  3. Funeral and burial expenses; medicine/health care up to six months before death; and payments for services by the deceased’s employees six months before death.
  4. The cost of a grave marker.
  5. Any rent the deceased still owed a landlord, incurred during the  six months before death.
  6. Everything else (credit cards, etc.)

Paying out the debts:  hypothetical example

Okay.  So supposing we sell the house and my mom’s estate has only $10,000 left in assets at this point.  (That’s not the real number, but all the other numbers in the example are real numbers from earlier in this series of articles.) Right away, $4100 (the $3500 we paid our lawyer plus the $600 I gave him for paperwork) comes out of category 1: filing fees and legal fees.  I paid that myself, so it now comes back to me — and it is not taxed as inheritance.  I didn’t inherit it that $4100; the estate was repaying what I loaned it.  The estate is now down to $5900.

Also in category 1, let’s say I’ve made $2000 in payments out of my own money to pay 4 months of mortgage and utilities.  All of that is considered “administration”, because it was used for the upkeep of the estate’s assets (the house). Okay, I get that $2000 back as well: the estate is down to $3900.

There’s no family exemption in our case, so category 2 is null.

Next up is category 3: funeral and burial expenses, and medical expenses (the copayment on her final stay at the hospital).  Well, I paid the medical bills myself (quickly after she died, no estate account involved), and I paid the funeral expenses myself.  So no need to fight over it; all the money in this category is now owed back to me.

The funeral was $9400 — oops, the estate only had $3900 left.  Well, I get all of that in repayment, but I am still owed another $5500 on the funeral, plus I paid $1420 for the burial.  So the estate now has a debt to me of $7020, but no other debts (yet).  We need to keep track of how much debt the estate owes me, the heir.  You’ll see why shortly.

Category 4: My wife bought my mom’s marker for $1200.  Assuming for simplicity that my wife and I manage all our money together, the estate now has a debt to us of $8220.

Category 5: My mom didn’t owe anyone rent; she owned her house (albeit with a mortgage on it).

Category 6: All that’s left is credit cards.  The credit card companies simply lose the money she owed them.  I do not inherit debt if I didn’t co-sign it.  But they may not give up that easily.  More on that in a moment.

Tiebreaking.  Supposing the estate runs out of money in the middle of a category.  Suppose we’ve paid off everything except her two credit cards, and there’s $1000 left.  Card A is owed $750 and Card B is owed $1000.  What happens?

Answer: All the remaining creditors each get a percentage of the remaining assets equal to their percentage of the debts.  It’s all proportional.  So in this case, the total debt is $1750; Card A is owed $750, which is 42.85% of the debt; Card B is owed $1000, which is 57.15% of the debt.  The total assets left are $1000; Card A therefore collects 42.85% of that, which is $428.50; Card B, in like manner, collects $571.50.

You see that this is somewhat fair.  If I die owing Bob ten times what I owe Janet, and can’t pay them both in full, Bob still gets ten times what Janet gets.

Insolvency and inheritance.  To continue before I digressed on tiebreaking: The hypothetical estate is now out of money.  But what’s the value of my inheritance? Recall that inheritance is not just what you get from the estate; it’s also from joint bank accounts and the IRA.

Suppose that I inherited a $50,000 IRA from my mom, and that she had $2000 in bank accounts jointly in her name and mine.  Only half of those bank accounts count as inheritance, remember, so I have inherited $51,000.  Since my inheritance tax rate as a descendant is 4.5%, I will now have to pay $2,295 (out of my own pocket) as inheritance tax.  Now that may not seem so bad, compared to the $51,000, but remember what we learned about the IRA: I might have to consider it taxable income.  So if I pull $2,295 out of the IRA to pay the inheritance tax, my taxable income just went up by that much, so now I owe more income tax, especially if it just put me into the next bracket.

However, I have inherited nothing from the estate; in fact, the estate owes me $8220.  The taxable value of my inheritance is reduced by the estate’s debt to me.  The value of my inheritance is therefore only $42,780.  My inheritance tax goes down by $369.90.  Well, that’s something at least.

Auditing. So regardless of the money I lost, I get some small satisfaction in telling the credit card companies they lose, right?  Well, it may not be that easy.

If the deceased owed enough money (and it’s up to the credit card company to decide what “enough” is), the company may decide to have its lawyers file a petition to compel the estate’s representative to file a detailed, documented account of the estate with the court.  This means a lot more hassle for you, and worst, it probably costs you another big chunk of legal fees.  Now those fees get counted as further legal fees (Category 1) on the estate — but the reason you told the credit card company to go away was because the estate was already out of money, which means that you’re effectively going to have to pay those additional fees out of your pocket.

Now of course, this does cost the company money, both for the petition and for the lawyers who could be doing other things, so they may just accept your claim that the estate is insolvent and go away, if the amount owed is small.

This is where you really, really need a lawyer to advise you of your options and help you choose a course of action.

Wait.  Why does the mortgage get paid before the funeral debts?  You might naively think: “Wait, I don’t see ‘mortgage’ on that debt priority list.  Supposing you sold the house for $70,000 to pay off a $60,000 mortgage.  Why don’t you take your $8220 and then tell the mortgage company that they get what’s left and they’ll have to suck up the $8220 shortfall, because your funeral payments come first?”

The problem is that’s not how selling a house works, whether you’re dealing with an estate or not.  You don’t get a big check for the sale price and then get to decide whether to pay off the mortgage with it or do other things.  The mortgage must be satisfied in the process of selling the house, or you (the estate) cannot be legally rid of the house.  So if the house sells for a profit of $10,000, that is all the estate gets from the sale.

The moral of the story. All of the above, ladies and gentlemen, is why you want to leave plenty of life insurance for your heirs if you can.  Let’s say my mom had $100,000 of life insurance.  (In reality, she had vastly less than that.)  That’s $100,000 that I would get, completely tax-free, no inheritance tax, does not count as taxable income (so not only is it not taxed itself, but it doesn’t raise me into a higher tax bracket), and I probably get it within a month or two of her death (assuming it was past the contestability period).  I could spend a whole lot more energy thinking about how to cope with my emotional loss, and a whole lot less on worrying about how to make my budget absorb the $8220 I’ve lost.  (In my hypothetical example, I’ve gained $50,000 in the IRA, but as you’ve already seen, that’s not the easiest thing to deal with, because any money I take from it is taxable income, and there are other complexities as well.)

Disclaimer: I AM NOT A LAWYER.  NONE OF WHAT I SAY HERE SHOULD BE CONSTRUED AS LEGAL ADVICE.  A LICENSED LAWYER SHOULD BE CONSULTED ON ALL LEGAL MATTERS PERTAINING TO ESTATES. The purpose of this article is to tell you some things I learned in the process of dealing with my mom’s estate, which you may want to think about in planning your own estate or dealing with a loved one’s estate.  Furthermore, details of some of these matters differ from state to state, so if you’re not in Pennsylvania, things may be different.  Consult your lawyer on all matters.

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