When an estate does not have enough money to pay all of the outstanding debts against it, some creditors have to simply forgive the amount that is owed. When this happens, it does not count as income for anyone as it would if the creditor were still alive to pay taxes on it.
Forgiven Debt as Income
When you have a debt and negotiate part of it away through a debt settlement, the creditor must forgive part of it. At this point, the debt that was forgiven is counted by the IRS as income on your part. Since you did not have to repay this debt, the IRS looks at it as if you made money. Because of this, you have to pay taxes on any debt that is forgiven.
Forgiven Estate Debt
When an individual passes away and his estate is worth less than his total liabilities, some creditors will not be paid. When this happens, the creditors can write off the amount that they were unable to collect as bad debt. This gives the companies a tax write-off. In this situation, no one is still alive to be taxed for the extra income. Because of this, no one is charged with the extra income that arises from the forgiven debt.
In this situation, the beneficiaries of an estate would not receive any inheritance. All of the property of the estate would have to be sold and the money would be used to repay creditors. When this occurs, the beneficiaries of the estate are not saddled with any of the debt from the estate. They also are not responsible for any of the income that would have been created by forgiving the debt of the estate.
Pay in Order
When an estate is insolvent, the executor must pay the creditors in order of priority with the available assets from the estate. State laws determine in what order creditors should be paid. For example, secured creditors come before unsecured creditors. The executor has to start at the top of the list and pay debts. Once the money or assets run out, the rest of the creditors will not receive anything for the debts they are owed.