Upside-Down Property at Death

Mark Dodds, Esq. discusses your estate planning process and options when dealing with real property that is upside down:

If the property is upside-down, it is best to leave the property out of a trust. Then, when the person with the trust dies, the trustee has no obligation as to the mortgage because the mortgage is not a debt of the trust as long as the trust is not a guarantor on the mortgage (and it is rare that the trust is a guarantor, but if it were, then the trustee would have to follow the procedure described below.)

So where the trust does not own the real estate and has no obligation on the mortgage, the trustee can do his normal notice to creditors, which gives creditors of the trust 90 days to file their claim, and if no claims are filed, or after any claims are filed and paid, then the trustee can distribute the trust estate. It is unlikely that the mortgage holder will pick up on the notice to creditors, and since the estate, which holds the upside down property, is a separate legal entity from the trust, the trustee has no duties concerning the mortgage, and can proceed to distribute the trust estate even though the home is upside down.

If the mortgage holder was very vigilant, they could get the estate opened and beat the 90-day notice period and file a claim against the trust, but as a practical matter that just isn’t going to happen. So as long as that trustee files the 90-day notice to creditors and then pays those creditors, the trustee has no risk of breach of fiduciary duty in distributing the assets of the trust even though there is a potential claim from the mortgage holder. If the mortgage holder does later foreclose and obtain a deficiency judgment, then the mortgage holder could go after the trust beneficiaries under a doctrine of recoupment, but the trustee would have no personal liability and the creditor/mortgagee would have to sue the beneficiaries individually, which would be a difficult prospect.

It is a little more complicated and risky in the case where the home is in the trust. In that case, the trustee will still file the 90-day notice to creditors, and the trustee is under a duty to specifically send notice to all creditors he/she is aware of or should reasonably be aware of. So obviously, the trustee of the trust, where the home is titled in the trust, is deemed to know about the mortgage on the property. So the trustee will send a notice to the mortgage holder that the owner died and that the mortgage holder must make a claim against the estate within 90 days of receipt of the notice. If the mortgage holder does so, then if the trustee were to distribute the estate anyway, the trustee would be in breach of fiduciary duty and would be personally liable for the mortgage deficiency. So unless the trustee is judgment proof and doesn’t care about being sued by the mortgagee, the trustee has to hold back sufficient funds to pay the mortgage deficiency.

Now, once the trustee has received notice of the claim, the mortgagee must then foreclose the property promptly and then after foreclosure, they have, of course, 6 months to bring a civil action for the deficiency, which would be brought against the trust. Certainly they can do this, but in practice, it just doesn’t seem to be happening. Legally though, it can, so the trustee must be sure to give notice to the mortgagee and then wait the statutory period after the foreclosure to see if there will be a judgment against the trust for the deficiency. If the 6-month period passes without a lawsuit being filed for the deficiency, then the trustee has no further duty to the mortgagee and can proceed to distribute the trust estate to the beneficiaries. If the mortgagee does get the judgment against the trust, then obviously the trustee must turn over trust assets, first from the residuary beneficiaries, and if insufficient, pro-rata from the specific bequests.

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