Family loans have significant implications for estate planning, and addressing these implications whilst everyone is alive prevents conflict and confusion after parents pass away.

How family loans affect inheritance

The most common estate planning question is whether a family loan should be considered an advancement on inheritance or additional help on top of whatever the child will receive from the estate.

If you intend the loan to be an advancement on inheritance, your will should explicitly state this. For example: "Any amounts lent to my children during my lifetime shall be treated as advancements on their inheritance and shall be accounted for when distributing my estate." This means if one child borrowed $100,000 and another borrowed $50,000, the first child would receive $50,000 less from the estate to equalise the distribution (assuming your will provides for equal treatment of children).

If you intend the loan to be additional help that doesn't affect inheritance, your will should state that all loans are to be forgiven upon death and the estate should be divided equally (or according to your wishes) without accounting for loans made during your lifetime.

The worst outcome is leaving this ambiguous. Executors and beneficiaries may have very different views about whether outstanding family loans should be deducted from that child's inheritance, leading to family disputes and potential litigation.

Forgiveness clauses in loan agreements

Many families include forgiveness clauses in their loan agreements that automatically convert the loan to a gift upon the death of both lenders. This approach has several advantages.

It avoids burdening the estate with collecting the debt from grieving children. It provides certainty for all children about what they'll inherit. It ensures the family home or other assets purchased with the loan don't need to be sold to repay the estate. It can simplify estate administration by eliminating a receivable asset from the estate.

However, forgiveness upon death also has potential disadvantages. It may create inequality between children if some borrowed substantially more than others. It reduces the estate available for other beneficiaries or purposes. It may affect asset protection if you're concerned about beneficiaries' creditors.

If you include a forgiveness clause, ensure your will is drafted consistently with this intention. Don't create a situation where your loan agreement says the debt is forgiven upon death but your will says the executor should collect all outstanding debts.

What happens if loans aren't forgiven

If your loan agreements don't include forgiveness clauses and your will doesn't address the loans, they become assets of your estate that the executor must deal with.

The executor has a legal duty to collect estate assets, which includes calling in family loans. This puts your child in the position of having to repay their siblings (as beneficiaries of the estate) the money you lent them, which can create significant financial stress and family tension.

Some children may not have the means to repay large loans immediately after a parent's death. The executor may need to negotiate repayment terms, which can delay estate distribution to other beneficiaries. In extreme cases, the executor may need to take legal action to enforce repayment, causing family conflict.

To avoid these scenarios, address family loans explicitly in your estate planning documents, either through forgiveness clauses in the loan agreements or clear directions in your will.

Treating multiple children fairly

If you've lent money to one child but not others, your estate plan should address whether this creates an imbalance that should be corrected. There are several approaches:

Equalisation approach: Your will provides that children who didn't receive loans get an equivalent amount from the estate before remaining assets are divided. For example, if you lent one child $100,000, another child receives the first $100,000 from your estate before anything is shared.

Loan advancement approach: Loans are treated as advancements on inheritance, and the borrowing child receives less (or nothing) from the estate depending on what they already borrowed.

Separate treatment approach: Loans are forgiven upon death and the estate is divided equally among all children without accounting for loans. This treats the loans as additional help given during your lifetime based on need at the time.

No adjustment approach: Outstanding loans remain debts owed to the estate, to be repaid before that child receives their inheritance share.

Each approach has merit depending on your family's circumstances and values. The critical point is making your intention clear in your will so your executor and children aren't left guessing what you wanted.

Testamentary trusts and family loans

Some families use testamentary trusts (trusts created by will upon death) to hold family loan debts. Rather than forgiving loans or requiring immediate repayment, the will might provide that outstanding family loans become assets of a testamentary trust that continues to hold the debt but with flexible repayment terms.

This approach allows the family loan to continue benefiting the borrowing child through flexible terms whilst ensuring the debt eventually flows back to benefit all children through the trust structure. It can be particularly useful when loans are large and immediate repayment would cause financial hardship, but you want to preserve some element of fairness between children.

Testamentary trusts add complexity and cost to estate administration, so this approach is typically only suitable for larger estates and substantial family loans.

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