In our estates practice we frequently find debts held in an Estate that are owed by a family member. Frequently these loans are forgiven or are distributed out to a debtor child pursuant to the terms of the decedents Will. Even when such debts are not specifically handled by the will in that manner, such debts are normally worked into the child’s share of the estate and distributed or written off that way. For most debts, no tax problems ensue. A forgiveness of debt that is in the nature of a distribution under a Will generally does not carry with it any income tax to the debtor/beneficiary who benefits from the forgiveness.
Debts owed to the estate that arise from a previous sale of property by the decedent present a very different picture, however. Assume that Father sells a rental property to Son for $100,000. The deed immediately transfers, and Son agrees to pay off Father over a period of ten years. This is, in popular parlance, an installment sale. Moreover, unless Father elects out of installment sale treatment and agrees to be taxed on the whole gain in the year of the deed transfer (which would be uncommon and, all other things being equal, not very wise), this is an installment sale in the eyes of the IRS. That means that each year Father is taxed only on portions of the payment received that year. That payment is divvied-up as return of basis (no tax), capital gain (taxable at either long term or ordinary rates), and ordinary income.
Assume that Father dies in year three of the payment schedule. If these notes are cancelled by the Estate, the cancellation again generates no taxable income for the beneficiary/debtor, however, the estate/seller has to essentially recognize receipt of the balance of the debt proceeds at the time of cancellation (otherwise the gain and other taxable items on the sales proceeds will never be taxed). Essentially, the taxable gain is accelerated into the year the debt is forgiven. A similar result occurs if during Father’s lifetime, he forgives Son’s debt. Such a forgiveness would be a taxable event on Father’s return during the year the forgiveness was made (and there may be gift tax consequences as well).
An installment sale can be a great approach to selling an asset. Because no third party lender is involved, it can be a way to get a transaction done with a particular buyer that otherwise would not get done. When it is done with a child, it can be a way of selling the property while leaving the flexibility to later work out the pay-off of that payment as part of the Seller’s estate plan. However, ultimately the Internal Revenue Service will find a way to be paid.
Apart from simply being ready for the above-outlined tax result, there may be steps that can be taken to mitigate the tax damage an installment sale can do. Additionally, for large estates, there is also the potential that too sweet an installment sale to a child could be re-characterized as a part gift to the child for gift and later estate tax purposes. In either case, these transactions should not be handled casually. If you have any questions about the effects of debt in your future estate, please do not hesitate to call.
– Rod Fluck