Perhaps one of the least understood tax benefits, a housing allowance (also called a parsonage allowance or rental allowance) is defined as a designated portion of a minister’s salary that is used toward expenses incurred in providing housing.
This portion of the minister’s salary is excludable from gross income for income tax purposes (but should be included in gross income for self-employment tax purposes) and may represent a substantial tax benefit for qualifying clergy based on Section 107 of the Internal Revenue Code.
While simple on its face, it’s important to understand the more complex tax implications for housing allowances. To take advantage of any tax deductions, churches, ministers and members of the clergy (or their tax professionals) should have a thorough understanding of what can be included in an allowance and how to account for it on a W-2.
Below we’ve outlined some of the basics to provide a broad overview. (As always, it’s important to review any housing allowances with your CPA at tax time.)
It’s important to note that just because an organization classifies someone as clergy does not necessarily mean that the Internal Revenue Service considers that person to be clergy, and often, individual facts and circumstances are taken into account when determining eligibility for a minister’s housing allowance.
According to the basic IRS definition, clergy—whether Christian, Jewish, Muslim or other—are “individuals who are duly ordained, commissioned or licensed by a religious body constituting a church or church denomination.”
Other church employees, such as janitors or secretarial staff, are not eligible for a housing allowance under IRS tax guidelines.
Housing allowances for a qualifying religious organization must be designated in advance and must be for a definite amount and specified before they are paid. They are never retroactive; in other words, they must be designated in advance of the calendar or fiscal year.
In addition, the individual must have actually spent the allowance on eligible housing expenses during the year in question.
They also must be adopted by the organization’s board or leadership. The allowance should be recorded in written form—such as a board-approved resolution—to avoid problems in the event the allowance is ever challenged.
While no specific percentage or dollar limitation exists in the tax code, the allowance may not be disproportionate to the amount of service rendered and must be deemed “reasonable compensation” by the IRS to qualify for tax benefits.
Some individual circumstances may be taken into account when determining how much income can be designated as a housing allowance.
For example, while many ministers, priests or other members of the clergy perform their duties on a full-time basis, others may need to take an outside job to supplement their income if a church of a smaller size or in a depressed economic area cannot provide a living wage. These individuals are classified as being “bi-vocational.”
In other cases, a clergyman without formal installation may supply services for a limited time as an organization’s acting pastor, rabbi or other leader. These individuals are called “supply pastors.”
In both cases, a housing allowance designation may be for up to 100 percent of their cash compensation but cannot exceed IRS-defined reasonable compensation.
A housing allowance may include expenses related to renting, purchasing (which may consist of down payments or mortgage payments) and/or maintaining a clergy member’s current home. (It may not encompass expenses incurred as the result of commercial properties or vacation homes.)
Any items for inclusion must be personal in nature for the clergy member and cannot include business expenses. However, a home equity loan used to pay for expenses related to post-secondary tuition is not eligible as a parsonage allowance.
Other areas for consideration are:
Members of the clergy may use home mortgage interest as part of their qualifying expenses for the housing allowance deduction and may also claim the same personal deductions on Form 1040’s Schedule A of their tax returns.
Property insurance-related expenses (including property contents) may qualify as a deduction if not already included in mortgage payments.
As with insurance, the inclusion of real-estate taxes may provide housing allowance tax benefits if not already included in mortgage payments.
Homeowners association dues for the clergy member’s primary residence may be excludable from income for tax purposes.
If no parsonage is provided and you are excluding the fair market rental value of a home, you may include utility and garage expenses inclusive of items like heat, electric, basic telephone, and water.
If living in a parsonage with utilities paid in full, individuals must estimate the anticipated expense to maintain the home above and beyond what is provided by the qualifying religious organization.
Clergy living in parsonages provided by a qualifying religious organization may designate part of their compensation to cover costs relating to the maintenance of the home.
Clergy living in parsonages provided by a qualifying religious organization may designate part of their compensation to cover costs relating to the maintenance of the home (providing they aren’t reimbursed by the organization). This may include items like:
As well as purchases for the home such as:
However, the tax code does specifically exclude items such as paper products, personal toiletry, grocery, maid service, and personal clothing expenses.
The housing allowance is reported in box 14 of form W-2. However, the portion paid to the employee for housing allowance is not included in box 1 of the W-2.
As with all financial record keeping, it is vital that in the case of housing allowances, members of the clergy keep appropriate, accurate and detailed records on home expenses to support tax returns in case they are ever audited. The records should be organized for retrieval when necessary.
As a rule, keeping records for seven years is sufficient to defend tax audits.
The tax code states that if you receive as part of your salary an amount officially designated as a housing allowance, the lesser of the following items are excludable from gross income:
You must be able to provide an audit trail and prove with receipts and other paperwork that you incurred enough expenses to substantiate your housing allowance.
It’s important to note that any housing allowance exceeding the IRS allowable amount will be reclassified as income and will be subject to income tax.
Many clergy members make the mistake of assuming their housing allowance is entirely tax-free. Although housing allowances can provide significant tax benefits, these individuals must still pay self-employment taxes on housing allowance income.
In one example, if a minister has not spent the designated housing allowance in its entirety (for appropriate expenses) during the year, then the difference between the designated amount and actual expenses must be included in ministerial income on the federal income tax form.
Additionally, the housing allowance income is subject to self-employment tax along with wages reported in box 1 of Form W-2.
Also important to bear in mind is that while the amount subject to income tax includes gross wages minus housing allowance (and any other pre-tax benefits), the entire clergy salary is subject to self-employment tax.
If tax preparation is challenging for the general public, it can be even more so for members of the clergy, especially given recent changes to the tax code. That’s why tax preparers who specialize in this area can be an invaluable partner when tax time rolls around.
The team at Ascension CPA can provide expert guidance on these and other specialized tax matters. For more information on this subject, we invite you to download our Housing Allowance Worksheet Package for Clergy and Churches.