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What to do when you inherit a money mess

Shelly K. Schwartz, Special to CNBC.com

Inheriting a money mess

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When a loved one dies, it's one thing to have to go through a basement full of boxes and quite another to get stuck with the departed's debt.

From tax liens and credit card bills to mortgages and student loans (debt that is at record levels among seniors) heirs are often forced to contend with creditors when they become beneficiaries to an estate.

"It happens all the time," said Austin Frye, an estate planning attorney and certified financial planner with Frye Financial Center in Aventura, Fla. "Even with wealthier estates, there are still debts to be dealt with. Some of that debt sticks to the asset itself and some is just general estate debt, and they're dealt with differently."

Click ahead to get tips on what to do if you inherit a money mess.

—By Shelly K. Schwartz, Special to CNBC
Posted 8 Oct. 2013

Am I always responsible?

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Generally speaking, Frye said, you're not obligated to pay the bills a decendant leaves behind. But you won't be able to inherit any part of the estate until creditors are made whole.

The estate's assets are inventoried under probate, liquidated as necessary and used to pay off any tax liabilities, secured debt (mortgages and car loans) and unsecured debt (credit cards and personal loans). Whatever property remains is then distributed as the will directs.

If assets are insufficient to cover liabilities, the lender typically takes the loss.

Can I negotiate?

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As heir, you can either walk away from the inheritance and the debt disappears, or you can deal with lenders to reduce the balance—a better choice if you hope to lay claim to that 1955 Thunderbird convertible your grandfather left in your name.

"My advice to inheritors is to negotiate," Frye said. "The courts want to see all debt paid before you get what's left."

When is it my problem?

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There are, of course, instances in which another's financial loose ends become your headache.

Those who co-sign for a loan, for example, are financially liable for that debt if the borrower defaults or dies, said David Mendels, a certified financial planner with Creative Financial Concepts in New York.

For that reason, adult children particularly should be wary of attaching their name to loans for mortgages, nursing home care or medical procedures for an aging parent, he said.

Widows and widowers living in so-called community property states, in which property acquired during a marriage is considered jointly owned, may also be on the hook for a deceased spouse's debt.

Those states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Regardless of where you reside, however, it is critical for all beneficiaries to understand who is entitled to what, so they can negotiate with lenders as needed and put creditors that are not entitled to their inheritance in their place when they threaten collection and ruined credit scores.

What's the tax picture?

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Tax liabilities left by parents and grandparents don't convey to their heirs but can take a big chunk out of an inheritance.

If your loved one owed back taxes to Uncle Sam, the estate will be used to pay them.

Depending on the assets' value, it also may be subject to federal and state estate tax, plus state inheritance tax, leaving beneficiaries with far less than they hoped for.

The federal estate tax exclusion for 2013 is $5.25 million; any amount above that is taxed at 40 percent.

That sounds like a lot, and it is, but keep in mind that life insurance policies, while not subject to creditor payment, can push beneficiaries over the exclusion limit.

"Life insurance policies can be structured so they're excluded from estate tax," said Mendels, adding that legal counsel is imperative. "It depends on who legally owns it."

More than a dozen states levy their own estate tax of up to 16 percent for any assets over an exclusion limit, which often is $1 million or less.

New Jersey, for example, taxes estates of more than $675,000 and imposes a separate inheritance tax of up to 16 percent on estates over $1 million.

The bottom line: Don't rush out and buy the beach house when you come into an inheritance until you know what's yours to keep.

What about credit cards?

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The estate pays off credit card bills and personal loans—types of unsecured debt—with the lender writing off any remaining balance.

This is where you may have the most leeway to work with lenders if the estate lacks the assets to cover the bill, according to Frye.

"The credit card companies have already written this debt off, so if they can get 25 percent they're ahead of the game," he said.

As with other forms of debt, if you co-signed for the credit card or attached your name to the loan, you will be stuck for it.

Mendels noted another point to be careful about: If you are divorced and your ex agreed to pay off a joint credit card as part of the settlement and failed to do so, you are responsible for that balance if he or she dies.


How are mortgages handled?

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Home mortgages are secured loans, meaning assets tied to the loan serve as collateral to guarantee the balance. As such, the lender is among the first to get paid if the borrower defaults or dies.

Several scenarios are possible when you inherit a home that isn't paid for.

If the estate has enough money to cover it, you can pay off the mortgage and claim ownership of the property. Or you may be able to assume the mortgage and continue payments in your name.

If the property is underwater (worth less than what's owed) you can also use a portion of the inherited estate to pay enough off so that it's no longer inverted. Then refinance and assume the loan.

If none of those options appeal or you just don't want the property, you can give it back to the bank, which will sell it to pay off as much of the balance as possible. Your credit will not be affected, Mendels said.

He points out that state laws differ regarding whether real estate passes through probate and that most lenders have their own rules for whether beneficiaries can assume mortgage payments.

As an heir, determining how to handle an inherited property must be determined case by case.

Are student loans treated differently?

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Student debt is not something most people associate with seniors. But they should.

The average student loan balance for those 60 and older reached $19,521 last year, up from $11,780 in early 2005, according to the Federal Reserve Bank of New York.

Some 12.5 percent of these loans were more than 60 days delinquent on their payments in 2012, up from 6 percent in 2005.

Federal student loans—including direct, Federal Family Education and Perkins loans—are discharged if the borrower dies.

Parent PLUS borrowers may also have their loan forgiven if they, or the student on whose behalf they obtained it, dies.

But private student loans are not forgiven, leaving the estate to pick up the tab.

Can I refuse the inheritance?

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Coping with the loss of a loved one becomes more difficult when beneficiaries are forced to untangle the money mess they've left.

If the estate is insolvent or the mortgage underwater, you can always decline to accept an inheritance, Frye said, but working with lenders to reduce the balance is often worth a try.