November 20, 2012
A Minister’s Most Important Tax Break
Summing up the housing allowance exclusion
This article is adapted from Richard Hammar’s Essential Guide to Money for Church Boards eBook. For this eBook and other cutting-edge eBooks for church administrators, board members, and clergy, view our online catalog.
The most important tax benefit available to ministers who own or rent their home is the housing allowance exclusion.
To the extent the allowance represents compensation for ministerial services, is used to pay housing expenses, and doesn’t exceed the fair rental value of the home, including utilities, ministers who own their home do not pay federal income taxes on the amount of their compensation that their church designates in advance as a housing allowance. Housing-related expenses include mortgage payments, utilities, repairs, furnishings, insurance, property taxes, remodeling expenses, and maintenance.
For ministers who rent a home or apartment, all of the above is true, with the only difference being the allowance is used to pay rental expenses, such as rent, furnishings, utilities, and insurance.
Note that a housing allowance does not cost the church anything. It simply represents a re-designation of part of a minister’s salary as a housing allowance. To illustrate, if a church board decides to pay the senior pastor $40,000 as total compensation for next year, it simply designates some portion of this amount as a housing allowance. The amount so designated is tax-free to the pastor in computing federal income taxes so long as it’s used to pay housing expenses and doesn’t exceed the home's fair rental value plus utilities.
Here are a few more points to help you understand the housing allowance:
1. Housing allowances cannot be designated retroactively. If your church has not yet designated a housing allowance for your pastor for this entire year, you cannot do so retroactively. However, you can designate one at any time during the year, so long as it operates prospectively.
2. Most churches base their pastor's housing allowance on a housing expense form that the pastor submits to the board or a compensation committee.
3. You can amend a housing allowance during the year if your pastor's housing expenses turn out to be higher or lower than expected—but, an amendment only operates prospectively.
4. The housing allowance usually is designated by the church board, but it also can be designated by the congregation or by a compensation committee. It should be an official action of whatever body that designates it, and noted in the minutes.
5. Only credentialed ministers are eligible for a housing allowance. Many churches employ a youth director or music minister who isn’t ordained, commissioned, or licensed. Even if such persons perform ministerial duties, they aren’t considered ministers by the IRS and so they aren’t eligible for a housing allowance. And, in some cases a church will employ a credentialed minister to perform non-ministerial duties, such as bookkeeping or maintenance. Since these ministers aren’t being compensated for ministerial services, they aren’t eligible for a housing allowance.
6. The housing allowance is taxable to the extent that it exceeds the lesser of housing expenses or the fair rental value of the minister's home. This often will be the case, since the housing allowance typically is higher than a minister's anticipated expenses. The excess must be reported as taxable income by the minister. It’s a good practice for the church board to remind ministers who own their home of this requirement. The annual Church and Clergy Tax Guide contains housing expense forms that church boards can use, and these forms clearly inform ministers of this requirement.
7. The housing allowance exclusion is an exclusion for federal income taxes only. Ministers must include the housing allowance as income in reporting self-employment taxes.
8. Churches aren’t required to report a housing allowance on a minister's W-2 form. It isn’t reported as wages because it’s an exclusion. Some churches insert the amount of the housing allowance in box 14, which is labeled “other.” However, this is optional.