Arguably, one of the first tax breaks for ministers dates back to Old Testament times. Genesis 47:26 reads, “So Joseph crafted a statute concerning Egypt that remains valid to this day that Pharaoh should own a fifth of the produce, excluding the land belonging to the priests, which remained outside of Pharaoh’s control.”
Several thousand years later, today, the Internal Revenue Code still recognizes certain tax benefits for ministers (i.e. pastors or priests). Among them is the ministers housing allowance, which is likely the most important tax benefit readily available to ministers. Basically, it allows them to exclude from gross income (thus avoiding taxation) some or all of their ministerial income that is designated by their church as a “housing allowance.” Practically speaking, this means the church should not include the housing allowance on the minister’s Form W-2.
The church must officially designate the allowance as a “housing allowance” before paying it to the pastor or priest. The rules for this tax exclusion found in IRC §107. http://www.law.cornell.edu/uscode/text/26/107
This tax exclusion raises certain questions, though, for example: What if the minister is given a monthly allowance but he does not use it all? What if the church provides the minister with a house instead of giving him a monthly allowance? Can he still avoid taxation on it? Or what if the minister already owns his home—does he lose the tax benefit? We answer these questions and others in turn.
First, a minister receiving a housing allowance from the church may avoid taxation on it only to the extent he actually uses it to pay home expenses (e.g. rent, mortgage interest, utilities, home repairs). The amount he does not use on home expenses must be included in his gross income (and thus taxed).
Second, if the church provides the minister with a home—that is, he lives rent free—then he may still benefit from the tax exclusion. He is not required to include in his income the fair rent amount of the home; and the church can also provide him with an allowance for any repairs, utilities, or furniture expenses, etc. When a minister lives rent-free in a church-owned home, the minister may exclude from income the lesser of these amounts: (i) the housing allowance the church provides him; and (ii) his actual housing expenses that the church does not pay for (e.g. property taxes, insurance, repairs, furniture, etc.). Thus, if (i) is more than (ii), the difference gets taxed.
Third, if the minister owns his home, he can still claim deductions for mortgage interest and real property taxes. In addition, the minister can exclude from income the housing allowance, but if the allowance is more than his reasonable compensation, his actual expenses, or the fair rent of the home, then that overage amount must be picked back up in income and thus taxed. This means that ministers who are also homeowners may exclude from income an amount that is equal to the lesser of these three amounts: (i) the housing allowance the church designates for him, provided it does not exceed his reasonable compensation amount; (ii) his actual housing expenses (e.g. mortgage payment, property taxes, insurance, repairs); and (iii) the fair rent of the home. In sum, the minister owning his home may both exclude from income the church’s housing allowance, and he may claim a deduction for his mortgage interest and property taxes.
There is some downside if a minister owns his home debt free. When a minister pays off his mortgage, his housing allowance generally decreases—and so does his tax benefit. When the property had debt on it, his loan payments qualified as housing allowance expenses. Consequently, ministers sometimes then seek to take a home equity loan out after they pay off the mortgage. Unfortunately, the Tax Court provides that a minister’s subsequent loan payments on this new loan are not housing allowance expenses—unless the loan was for repairs and other housing-related expenses.
If a minister rents a home, he can exclude from income an amount equal to the lesser of (i) the housing allowance the church designates for him, and (ii) his actual housing expenses (e.g. mortgage payment, property taxes, insurance, repairs).
What practical steps should a church do to officially designate a ministers housing allowance?
As mentioned, the church must officially designate an amount as a “housing allowance” it pays it to the minster. If the church does not do this, the minister may be required to pay tax on the amount he receives.
Thus, the church should take affirmative steps to designate (officially) the amount the minister shall receive is his “housing allowance.” To make its determination, the board should inquire how much the minister needs for housing expenses. The elder board should then include the agreed upon amount in its meeting minutes. It could also be a provision in the minister’s employment contract. Pursuant to Treas. Reg. § 1.107-1(b), the designation may appear in the minister’s employment contract, the church minutes, the church budget, or any other document indicating official action. The minister’s housing allowance should be an action item each year, unless the employment agreement provides otherwise.
The church should not forget or fail to designate the minister’s housing allowance because retrospective designations are disallowed. Practically speaking, a minister cannot backdate a resolution by the elder board if the board failed (or forgot) to designate his housing allowance. If he does backdate it, he could be fined by the IRS or even imprisoned. It could result in civil or criminal penalties. See elsewhere on this site for more about tax fraud or tax evasion. Finally, if the church’s organization documents adopted provisions of the Sarbanes-Oxley Act, the minister could also be in violation of that Act for backdating a board’s resolution. The IRS has a specific “Ministers Audit Techniques Guide” giving IRS personnel techniques for when they audit ministers.