Many Californians create a living trust with a simple goal: make things easier for their family. But one issue catches families by surprise: What happens if the trust doesn’t have enough money to pay off debts, liens or mortgages at death, even when the trust says property should be distributed “free and clear?”
The short answer is this: A trust cannot erase a mortgage or lien. If the trust doesn’t have the funds to pay it off, the debt usually stays attached to the property.
Trusts often include language stating that a home or other real property should pass to a beneficiary “free of any encumbrances and liens.” People understandably assume this means the mortgage will be paid off automatically. In reality, “free and clear” is an instruction, not a guarantee. It only works if the trust has enough cash or other assets to pay off the debt. If it doesn’t, the trustee must administer the trust based on what is actually available.
A mortgage, deed of trust or tax lien is a secured debt. That means the lender has a legal right tied directly to the property. Even if the trust says the beneficiary should receive the home free of debt, the lender’s rights remain. If mortgage payments stop after death, the lender can begin foreclosure, just as they could if the property were owned outside a trust. This is often shocking to families who believe the trust “protects” the home from creditors.
When the trust lacks sufficient funds, the successor trustee has to make practical decisions. In some cases, the property can be distributed to the beneficiary with the mortgage still attached. The beneficiary can then choose whether to keep the home and continue payments, refinance or sell. Needing to sell the property is especially common when the trust needs cash to pay administration expenses, final bills or taxes. If the mortgage balance is high and the property has little equity, selling may be the only realistic option.
Sometimes the trust has enough assets overall, but not enough cash. In that situation, the trustee may sell other trust assets to raise funds. This can create tension if one beneficiary is receiving a house while others are expecting cash.
When a trust does not have enough money to pay everything, the trust terms and California law determine which gifts are reduced first. Usually, the “residue” of the trust bears the burden. But depending on the structure of the plan, even specific gifts can be reduced or sold to satisfy debts and expenses.
If your trust includes real property with a mortgage, it is important to understand that the debt does not disappear at death. A trust can help avoid probate, but it does not eliminate liens. The best plans anticipate this issue and include clear instructions for what should happen if there is not enough liquidity to pay debts.
If you own property with debt, talk with your estate planning attorney about whether your trust is structured to handle it and whether your loved ones will realistically be able to keep the property after you’re gone.
Send your questions to ccolan@colanlegal.com and use “Alpine Mountaineer estate planning question” as the subject. We’ll answer your questions in our upcoming issues. This article is provided by your local estate planning attorney, Corina Colan. The Law Office of Corina I. Colan / (909) 265-3315 / www.colanlegal.com
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