Private Note - What happens when the holder of the Note Dies?

Question

Hello,

I have been fine tuning my plan to seek Private Investors (all of whom I know personally). I want to make sure I have thorough, accurate, and easy to understand answers to the questions I anticipate they will likely have.

One thing that I have not seen on here and expect will come up is this;

• Say I borrow money from 'Bob' for a loan which may be a traditional loan or a non-recourse loan (if it is for the properties within my SDIRA). Assume it is 75K @ 6% with a 15 year amortization. Assume a mortgage is recorded and all other paper work is done the same as if borrowing from a bank or credit union.
• What happens if 'Bob' passes away while I still owe on this Note? Would it be 'called due', or would the Note just go to whomever he assigns (not sure if that is the right term) to in his Will?
• Is there a different tax consequence to the lender in either of these scenarios?
• Would this be any different if the lender was ALSO the owner of the property......... I am thinking in the case of a Land Contract?
• Thinking of 'older couples'..... say a farm couple both in their early 70s, or in any other case too, is there any pros or cons for THEM (it seems like it would not make a difference to me) whether one or both of them are the lenders to me as far as taxes, estate planning, etc.... goes?

Thanks for all the help you all offer here on BP,

Dan Dietz

Jon Holdman · Answer

Unless you're a CPA or EA you should be very careful giving tax advice to your potential lenders.  You should advise them there are tax implications and tell them to seek information from their own accountant.

At the simplest, the heirs would continue to pay tax only on the interest.  That doesn't change.  What could potentially change is the basis, as @Bill Gulley is saying.  When a heir inherits an asset they get the asset with a "stepped up basis".  That is, the value (which is not subject to tax, unless its a big estate) is the value on the date of the death.  This really comes into play on real estate.  Say someone bought a house for $50K 30 years ago and when they die its worth $300K.   The heirs turn around and sell it for $325K (after costs) a couple of years later.  They would owe tax only on the $25K gain over the $300K value on the date of death.  Not on $275K of gain over the decedent's basis.

IDK if this applies to notes.   Or, how you might establish a higher value than the unpaid balance on the date of death.

Matt Inouye · Answer

@Bill Gulley, and @Jon Holdman

I know this is an old thread but I have a similar situation to @Daniel Dietz with a bit of a twist.

What happens if a note is modified and a few years later the private lender passes away (leaving the note to the state - no heirs).

I tried to go to the county recorders office but was told that they do not record modifications to note terms.  How would the beneficiaries (in this case the state) know that the private lender and I had modified the terms if recorder's office doesn't record that information?

The document that I had prepared is notarized by the private lender and myself.

Any thoughts and insights would be appreciated.

Aloha,

Matt

John Rooster · Answer

No, it would not become due. As has been stated it would become part of the note holder's Estate. You would then become a 'person of interest' as to the police investigator.

Bill Gulley · Answer

I've never seen a private note that could be valued at a premium, regardless of the note rate, they will be at a discount.

There are instances where someone has a trust. Trusts must be valued annually, admin fees are based on the portfolio under management, discounting saves a bit.

Notes held in partnerships establish net worth, if a partner buys out another they will want a discounted market value approach, the buyer will want market value.

Notes traded for other assets or used for collateral will be discounted.

The market value of assets must be determined for individuals to qualify for medical benefits, this is the lion's share of evaluations. The discount allows them to qualify for benefits and not be required to pay for care of phantom equity in notes.

Law suites, the court or attorneys may want a liquidation value.

Bankruptcy will look to the market value of assets, amounts available for creditors.

I had several where amounts of an estate in excess of stated dollars was to be donated to charity. There are estate planning issues that will consider market values in setting up a charitable remainder trust or other goals to be met.

It's not just mortgages, any annuity type contract that is assignable may be determined as to it's market value. Leases and accounts receivables may also be subject of an appraisal. :)

Jon Holdman · Answer

And when you do, you won't care about any of this stuff.

With a mortgaged property, any increase in value goes to the owner of the property, not the lender.  So, I think it would be very tough to make any claim that the value of the note is higher than the unpaid balance.  OTOH, it may be possible the value of the note is less than the unpaid balance.  I'd even go so far as to say the value of most notes is less than the unpaid balance. But I cannot see any benefit to the heirs to try to reduce the value of the note.

Bill Gulley · Answer

I agree Jon, there is no reason for an investor type to go into taxes, just tell them they need to speak to their tax advisor (most won't investigate the matter).

I'd say the same % of the principal needs to be followed as the note is the asset conveyed. In the house sale, RE value is assessed in the estate valuation which establishes the new basis. I was the only one in the state that I'm aware of (probably a much larger area) and I was never asked to value a note for an estate arising from death. But to set a value of the note it would need to be appraised. It's customary that an estate simply uses the unpaid balance owing.

Mine are in trust, so I won't have the issues.

Since I've never died before I can't say. :)

Bill Gulley · Answer

Dan, you don' need to make payments on a note if they holder dies,

No! I'm pulling your leg, you do continue making payments, the holder's death has no effect on a borrower just as Jon outlined. :)

Contract for Deed or installment sales the holder pays on the interest as interest income. Say the seller had a basis of 5oK and sold it for 100K, that's 50%, and 50% of the principal is taxed as a gain as it is received in that tax period. The CFD also passes just as a note as Jon mentioned.

Loan terms do not change upon death as Jon mentioned and terms agreed to require such a balloon payment won't be enforceable.

BTW, for a borrower, it may be a good time to seek a discount of sorts by having the heirs pay for refinancing the loan! :)

Daniel Dietz · Answer

Thanks for the fast reply @Jon Holdman .

I assume what you are saying about "the terms of the note are not changed by a death" would also hold true for a Land Contract, as long as their was not a provision written into it otherwise?

Do any of you know enough to answer this; my understanding is that the lender only pays taxes on the INTEREST part of the payments, NOT the principal. Would that also hold true after a passing of that note onto heirs after a death? I understand that the value of the Note passes tax free assuming they are under the exemption, but then with the future payments the heirs received does that also hold true = they only pay taxes on future interest payments?

Thanks again,

Dan Dietz

Jon Holdman · Answer

For the lender a loan is an asset.  From their perspective, its like a bank CD.  In fact, it is exactly like a bank CD except that it (hopefully) offers a higher rate of return and it carries higher risk.

When someone dies, all their assets become part of their estate.   Its gets distributed to the heirs based on the arrangements put in place by the decedent.  This can include terms in the note itself, a will, or state law.

Assets transferred at death may incur taxes for the heirs.  That really only comes into play if the estate is large.  I think $5 million is the current threshold.  Otherwise, the heirs do not owe any taxes on what they receive.  Once they receive the asset, however, they begin paying taxes on the income the asset generates.  So the value of the note on the date of the death is not taxable (typically).  The interest the heir receives after the date of the death is taxable.

The terms of the loan are not changed by the death.

Private Note - What happens when the holder of the Note Dies?

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