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Who Inherits Your Debt?
CNBC.com | March 16, 2012 | 02:19 PM EDT

Your father passed away, naming you as the sole heir to his estate.

Unfortunately, that estate includes $30,000 in credit-card bills and a house with negative equity. So where does that leave you?

“We’re seeing a lot of that in Florida, where you’ve got condos being willed to children that are worth less than the mortgage note,” says Austin Frye, a certified financial planner and estate attorney with Frye Financial Center in Aventura, Fla.

The matter of what becomes of your debt when you die — home mortgages, car loans, medical bills, student loans — is more complex than it sounds.

Generally speaking, says Frye, personal debt dies with the borrower, thus can’t be passed along to children or spouses.

As with all things financial planning, though, exceptions abound.

Much depends on whose name is attached to the debt, the state in which you reside and the type of debt in question, says David Mendels, a certified financial planner with Creative Financial Concepts in New York.

“A lot depends on how the assets are titled, and the rules can vary by state,” he says. “Then there is the question of whether there were any guarantors on the debt. They could very well get stuck with the debt.”

Beware the Joint Account

If you’re insolvent when you die — meaning your assets are insufficient to cover your debts —there’s little to discuss. All debt disappears with you.

The executor of your estate will attempt to sell whatever collateral you have and pay off your creditors to the extent possible.

Everything else gets written off as a loss.

Those you leave behind, however, will not be responsible for making the creditors whole.

That is, of course, unless one of them co-signed for a loan or agreed to act as a guarantor.

In that case, says Mendels, the co-signer would be on the hook for any remaining balance after the original borrower dies.

That includes adult children who co-sign for an aging parent, or promise to cover medical or housing bills if their parent passes away.

“When you co-sign for something, you make a commitment to pay off that loan on the debtor’s behalf if they are no longer able to,” says Mendels. "That’s one of the many reasons people have to be careful about co-signing.”

The same is true with joint credit cards between husband and wife, says Frye.

If your dear departed used the joint credit line to restock the closet with designer duds, it’s you who gets stuck holding the bill, even if it wasn’t technically your spending spree.

Pay as You Go

If your estate is solvent when your ticker calls it quits (i.e. your assets are greater than your liabilities), your debt gets deducted from your estate and your heirs get what’s left over.

The executor of your estate will use your savings to pay off any debt before distributing the remaining assets to those named as beneficiaries in your will.

If your savings are insufficient, the executor may have to sell off some of your assets (including your car, stock accounts, or house) to make up the difference.

“Creditors always come before heirs,” says Mendels, noting that credit card companies, mortgage lenders and banks that are owed money get paid first. “All debts must be paid before the estate can distribute assets.”

Depending on your state laws, however, some assets may be excluded from probate — the process by which all claims against your estate get resolved after you die, says Frye.

That can include life insurance proceeds, retirement benefits and even real estate, if the surviving spouse’s name is listed on the mortgage as a co-owner.

In certain cases, such assets can be passed directly to the beneficiary named in the will, keeping those assets outside the estate and safe from hungry creditors. A probate attorney familiar with your state law can advise on specifics.

Community Property States

The rules related to debt are slightly different, however, if you are married and happen to live in a so-called community property state — California being the most notable — where all property (and debt) acquired during a marriage is considered jointly owned.

Thus, you may be responsible for paying off your husband’s midlife crisis sports car after he dies, even if you never knew it existed or agreed to co-sign for the loan, says Frye.

Other community property states include Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin, but their laws differ slightly. Here again, a probate attorney can advise on specific state laws.

Nursing Home Costs

Regardless of where you hang your hat, you may also be required to pay for your spouse’s nursing home expenses if he or she had Medicaid , the federal low-income health program, pick up the tab.

Gideon Rothschild, a partner and co-head of trusts and estates practice at Moses & Singer law firm in New York, says it’s common strategy for the healthier spouse to invoke “spousal refusal” and refuse to pay for such expenses incurred by their husband or wife.

The spouse needing the nursing home then claims “no assets” and Medicaid steps in with financial assistance — at least until that person dies.

At that time, says Rothschild, the federal government may come after the surviving spouse for payment.

“If the surviving spouse has significant assets, the government may sue him or her to recover the amount they paid out, or put a lien on their home,” he says, noting the government typically would wait to collect from the proceeds of the sale of the property after the second spouse passes away.

While the couple’s estate eventually does settle their debt, Rothschild says, getting Medicaid to pick up the bill while both parties are alive is often good planning since the government is charged far less for nursing home expenses than a consumer.

Student Loans

Student loans are a separate matter entirely.

Federal loans, including the Perkins and Stafford , offer loan forgiveness provisions if the student borrower dies before the debt gets repaid, says Mark Kantrowitz, publisher of financial aid website Finaid.org.

Likewise, the balance on federal PLUS loans for parents gets dismissed if the borrower or the student for whom the parent is borrowing passes away with an outstanding balance.

Private banks are not so forgiving.

“Some lenders are still really obstinate on this issue,” says Kantrowitz.

Starting in 2009, a handful of lenders, including Sallie Mae and New York State Higher Education Services Corp ., started offering “discharges,” which wipe the slate clean if the student borrower dies or becomes disabled.

But not all of their competitors have followed suit; some still force co-signers \(usually grieving parents\) to pay up.

“If your loan is not covered by one of these policies you can still ask the lender for a compassionate review process,” says Kantrowitz, adding the success rates vary by lender.

Don't Be Bullied

If you do not reside in a community property state and you didn’t co-sign for the loan, chances are you are not responsible for your spouse’s debt when he or she passes away.

But that doesn’t stop creditors from trying to collect.

Some credit card companies will send legal notifications to surviving family members, indicating their responsibility to pay off the decedent’s (deceased person's) debt.

Other lenders will threaten a lien against the house of the surviving spouse until the outstanding balance is paid.

Don’t allow yourself to be bullied, says Frye.

“Debt collectors will be very creative and persuasive,” he says, noting they themselves often do not know the laws regarding who’s responsible for debt. “They will also use terms like ‘moral responsibility’ and use the ‘guilt’ weapon against family members.”

His advice? “Tell debt collectors to take a hike,” and contact your attorney.

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