Who gets their inheritance when debts eat up part of the estate?

Many times in this blog I've talked about how debts and expenses of an estate are to be paid before the beneficiaries receive their inheritances. Now a reader has asked a really good question about the next step in that process, particularly where there might not be enough money in the estate to pay debts and expenses as well as all of the gifts set out in the will.

Here's the question:

"Cash gifts are distributed after the estate has paid expenses. If there are insufficient funds to pay the gifts are the prorated according to the funds available?"

The answer is a bit complicated but I'll do my best to keep it brief. By the way, I addressed this issue in a paper I wrote a couple of years ago for the Legal Education Society of Alberta called "Taxation of the Average Estate", which is available online by clicking here.

The first thing you have to do is read the will carefully to see whether it gives any specific instructions about paying taxes. Most don't, beyond giving a direction to the executor simply to pay debts. If there are specific instructions, then obviously you must follow them. The answer I'm giving below applies when there are no specific instructions in the will.

Let's say that John's will gives $5,000 to his friend Lucy, and divides the rest of the estate among his nephews, Frank, Lloyd and Joe. The gift to Lucy is called a specific gift. The gifts to Frank, Lloyd and Joe are residuary gifts because these three people share the residue, or rest, of the estate. The type of gift matters because debts are paid first from the residue. So if there were only $5,001 in John's estate after payment of debts, Lucy would get the $5,000 and the other three would split the last dollar.

Within the residue itself, personalty would be used up before realty. So if there were cash or vehicles in the residue, they would have to be sold and used to pay debts before real estate in the residue was sold for debts.

I believe this reader's question asks about what to do when there are several specific gifts to be paid and there isn't enough to pay all of them. If some of the gifts were cash and some were realty, cash gifts would have to be completely consumed by debts before realty gifts were used. So it could work out that one person (getting the lake lot for example) might still get that gift even though the next person didn't get their gift because it was cash.

If there were several gifts to be paid - all cash - and none were treated any differently than the others in the will, I would agree with the reader's suggestion to pro-rate them after payment of debts. It would be difficult for any one beneficiary to argue that he or she had been treated unfairly if this approach to division was used.

Keep in mind that if the recipient of any of those gifts is a dependent of the deceased (spouse, minor child, handicapped adult child), he or she might decide to contest the will to get a greater share. They have only a limited time to do this.