Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
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An elderly relative of mine made a loan to younger relative for some hundreds of thousands of dollars, secured by a lien on real property.
There was a promissory note and a 5% interest rate. There was no penalty for late payment, and in fact no payments were ever made, and all attempts at collection failed. The terms of the loan state that any unpaid amount would be subtracted from any inheritance to the same person.
With interest, the balance is now more than twice the original amount. The total estate is under $5m.
Now, do I have this right?
- If the loan is actually paid back because of some miracle, the interest paid is considered income and taxes must be paid by the lender. Same would apply if a different lender foreclosed on the property, if money was left over after paying more senior debts.
- If the debt is declared 'bad', both principal and interest are a deduction for the lender (offsetting a 25% tax bracket). The forgiven debt is income to the borrower (the individual is delinquent with the IRS and likely not paying taxes. The IRS may well foreclose on the same property.).
- If the elderly individual dies, the loan is an asset of the estate. If the loan is 'given' to the individual, she faces no tax consequences, and at that point can tear it up. The IRS gets nothing.
- If the elderly individual so decides, the debt could remains an asset of the estate and could be collected on by the estate. But at that point a bad debt deduction would result in no tax credit.
Do I have this about right? Then, um, how should this be handled?
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Is the borrower a beneficiary of the estate? If so, simply give them the value of the note plus accrued interest as a partial distribution of their share. They can then tear up the note. I have done this in several estates with the same situation.
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I agree with Gill unless the loan exceeds the value of the borrower's share of the inheritance.
Are there other heirs?
When a property is foreclosed upon payout is determined by the order in which the liens are recorded. Therefore if the loan was recorded prior to any IRS liens then the loan will be paid before the IRS. Whether the executor or other heirs have the stomach to foreclose on the deadbeat heir is another thing.
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I suggest you contact an attorney who practices in this area of law. I believe you have received good advice on this forum but this is a potentially litigious situation and you need good legal advice.
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What does the estate lawyer say? I am assuming with a near 5 million dollar estate there would be a lawyer involved to execute the will, no?
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How should this be handled by whom? The debtor, the lender, the lender's POA, or the executor?
Is the debtor a beneficiary, and will her share of the inheritance cover the debt, including interest? If yes to both, then the executor would consider the loan an asset of the estate, and could distribute the debtor's inheritance in part as loan forgiveness with no tax consequences.
If the loan is forgiven separate from the inheritance, the IRS would likely consider it a gift rather than a business loss, especially if no effort has been made to collect interest so far. But talk to an accountant or attorney about that, it's a grey area.