When someone dies with unpaid debts, the estate follows a probate process that dictates how and when debts and fees are paid. The exact procedure varies somewhat from state to state. In general, creditors file claims with the estate for their unpaid debts, such as mortgages, credit card debt and electricity bills. Each state's probate law dictates an order in which the bills are paid. All bills and fees are paid out of the estate before heirs receive any disbursements.
A decedent's tax obligations can be very complex. The executor must determine the value of all assets and money in the estate. If the total amount exceeds $5.25 million, as of 2013, the estate must file a return and pay estate taxes. The estate must also file a personal income tax return for the decedent's last year of life, both for federal and state taxes. In addition, if the estate's assets generate any income during the probate period (the time in which the estate is paying off debts and distributing assets to heirs), the estate must pay income tax on those proceeds.
An estate has a number of operating expenses that it must typically pay for, including legal fees, funeral costs, home maintenance costs, business costs and needs of surviving family. The executor is obligated to use more than just the estate's available cash to pay all these things. She will need to identify all the decedent's additional assets and have them appraised, such as real estate, life insurance and valuables. If cash is not enough to pay expenses, the executor will typically need to liquidate assets in the estate to pay the costs. In most states, this requires court approval.
If the estate runs out of money to pay bills and fees, the decedent's children are not responsible for paying off the rest of the debt. The estate will instead be declared insolvent and the remaining debts will go unpaid. State law dictates how the insolvency process works and should be followed exactly. Typically, the executor files a petition asking the court to declare the estate insolvent. Creditors are paid according to their order of priority, as dictated by state law, and the creditors left unpaid after the estate runs out of money are out of luck. Beneficiaries may not receive any assets if the estate was depleted paying off as many expenses as possible. In some states, certain assets may be protected from this process and still go to beneficiaries, such as life insurance benefits.