If Someone Pays Off Your Debt, Is That Income?

When another person pays off your debt, the tax implications depend on the specific circumstances. Factors like the relationship between individuals and the reason for the payoff influence how the Internal Revenue Service (IRS) views the transaction. This article clarifies when a debt payment on your behalf might become taxable income.

Understanding Cancellation of Debt Income

When a lender forgives or cancels a debt, the amount is generally considered taxable income to the debtor. This is known as Cancellation of Debt (COD) income. The IRS views this as an economic benefit because the debtor is no longer obligated to repay.

Creditors who cancel $600 or more of debt are typically required to issue Form 1099-C, “Cancellation of Debt,” to both the debtor and the IRS. This form reports the forgiven amount. Even without a Form 1099-C, canceled debt may still be taxable and should be reported.

The canceled amount is generally taxed as ordinary income, subject to your regular income tax rates. For example, $5,000 of canceled debt would typically be added to your other income for the year. This can affect your overall tax liability and potentially place you in a higher tax bracket.

Debt Paid Off as a Gift

When a third party, such as a family member or friend, pays off your debt without expecting anything in return, this is generally considered a gift. Money or property received as a gift is not taxable income to the recipient. The person who gives the gift, the donor, is typically responsible for any potential gift tax.

For 2025, an individual can give up to $19,000 per recipient without triggering gift tax reporting requirements for the donor. This is the annual gift tax exclusion. If a gift exceeds this amount, the donor must file Form 709, “United States Gift (and Generation-Skipping Transfer) Tax Return,” to report it to the IRS.

Exceeding the annual exclusion does not automatically mean the donor will pay gift tax. Individuals also have a lifetime gift tax exemption, which is $13.99 million per person for 2025. Amounts gifted above the annual exclusion reduce this lifetime exemption. Gift tax is only paid if cumulative lifetime gifts exceed this threshold. For example, if a parent pays off a child’s student loan, it would likely be treated as a gift, with no income tax consequences for the child.

Debt Paid Off as Compensation or Other Taxable Income

A third party paying off your debt may be considered taxable income for reasons other than a gift. The relationship between the payer and debtor, and the payment’s purpose, determine its taxability. These scenarios differ from typical cancellation of debt income because a third party makes the payment directly to the creditor, rather than the original lender forgiving the debt.

For instance, if an employer pays off an employee’s student loan or other personal debt, this amount is generally considered taxable compensation to the employee. The employer would typically include this amount on the employee’s Form W-2, “Wage and Tax Statement,” and it would be subject to income and payroll taxes.

Debt forgiveness might also occur as part of a legal settlement or award. If a court settlement results in a portion of your debt being paid or forgiven by another party, that amount may be classified as other income. The specific tax treatment depends on the claim’s origin and nature. In such cases, the recipient might receive a Form 1099-MISC or Form 1099-NEC, reporting the taxable amount.

Key Exclusions from Cancellation of Debt Income

While canceled debt is generally taxable, certain exclusions can prevent it from being included in your gross income, even if a Form 1099-C is issued. These exclusions are specific exceptions defined by tax law. If an exclusion applies, you typically report the excluded amount on Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” and attach it to your tax return.

Insolvency

This exclusion applies when your total liabilities exceed the fair market value of your total assets immediately before the debt cancellation. The amount of canceled debt you can exclude is limited to the extent of your insolvency. For example, if you are insolvent by $10,000 and $15,000 of debt is canceled, you can exclude $10,000, but the remaining $5,000 would be taxable.

Title 11 Bankruptcy Case

Debt discharged in a Title 11 bankruptcy case is also excluded from taxable income. This applies to all chapters of bankruptcy, including Chapters 7, 11, and 13, provided the discharge is granted by the court or is part of a court-approved plan. This exclusion takes precedence over the insolvency exclusion if both apply.

Qualified Principal Residence Indebtedness (QPRI)

This exclusion allows taxpayers to exclude debt reduced or forgiven on their primary home. It generally applies to debt discharged before January 1, 2026, and is limited to $750,000 ($375,000 for married individuals filing separately). The debt must have been incurred to acquire, construct, or substantially improve the primary residence, or to refinance such a debt.

Qualified Farm Indebtedness

This can also be excluded from income. To qualify, the debt must have been incurred directly in connection with the taxpayer’s farming business. At least 50% of the taxpayer’s gross receipts for the three preceding tax years must have come from farming. The discharge must also be by a qualified person, such as a lender in the business of lending or a government agency, not a related party.

Qualified Real Property Business Indebtedness

This allows a non-C corporation taxpayer to exclude certain debt incurred or assumed in connection with real property used in a trade or business, provided the debt is secured by that property.

Student Loan Discharges

Certain student loan discharges are not considered taxable income. Examples include those due to death or permanent disability of the borrower, specific income-driven repayment plans, or public service loan forgiveness programs. Some student loan discharges occurring after December 31, 2020, and before January 1, 2026, are also non-taxable.