Most religious leaders don’t choose their vocation for the tax perks. But a significant tax benefit is available through Section 107 of the Internal Revenue Code, which permits licensed, ordained, or commissioned clergy to exclude from their taxable gross income either (1) the monetary value of their organizationally provided housing (typically known as a “parsonage”), or (2) a monetary dollar amount known as the “housing allowance” as a portion of overall compensation. This article focuses on the housing allowance, including key background information about its history, employee eligibility based primarily on religious credentials and ministerial work responsibilities, the employer’s responsibility to designate a housing allowance in advance and in a sufficiently high amount, and related information for optimal tax compliance.
Historical Background of the Housing Allowance
Beginning in 1921, and soon after the individual income tax was upheld as constitutional, clergy living in employer-provided parsonages have been able to exclude the value of such housing from income tax liability under Section 107(1) of the Code. In 1954, Congress enacted Section 107(2) to bring parity for clergy living in either their own houses or in rented housing.[1]
As the federal Seventh Circuit Court of Appeals (covering Illinois, Wisconsin, and Indiana) recognized in its 2019 Gaylor v. Mnuchin ruling, both Section 107(1) and Section 107(2) are consistent with the Code’s Section 119 “convenience of the employer” income tax exclusion for certain employee housing. Against this historical backdrop, the Court recognized “an overarching arrangement in the tax code to exempt employer-provided housing for employees with certain job-related requirements.” Indeed, “ministers often use their homes as part of their ministry,” serving as safe havens to counsel troubled souls, forums for spiritual development, additional facilities for religious use, and a myriad of other purposes that benefit their communities. Consequently, rather than inviting a fact-intensive determination of whether a clergy member’s housing is sufficiently “ministerial” in the government’s eyes, the Court concluded that the clergy housing allowance exemption thus “eases the administration of the convenience-of-the-employer doctrine by providing a bright-line rule.” In short, Section 107(2) essentially allows the government to respect the independence of the religious sphere per the First Amendment, rather than establishing or favoring religion as opponents have contended.[2]
Clergy Eligibility for the Housing Allowance
The threshold question in determining whether an employee may claim the housing allowance exemption is whether the employee may be classified as a “Minister of the Gospel” – i.e., clergy.[3] It is widely understood that clergy have certain ministerial functions or characteristics as follows:
1. ordination, licensure, or commission;
2. authority to administer sacraments;
3. conducting religious worship;
4. controlling, governing, or maintaining a church or other religious organization; and
5. recognition as a religious leader by the minister’s church or denomination.
Unfortunately, legal authorities have exhibited some variance about just what measure of these ministerial functions must be present for an individual to qualify as a Minister of the Gospel.
The Narrow View
The IRS and some tax courts have adopted a restrictive view of who qualifies as a Minister of the Gospel. The IRS has described this restrictive view as follows:
Ministers are individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination. Ministers have the authority to conduct religious worship, perform sacerdotal functions, and administer ordinances or sacraments according to the prescribed tenets and practices of that church or denomination. If a church or denomination ordains some ministers and licenses or commissions others, anyone licensed or commissioned must be able to perform substantially all the religious functions of an ordained minister to be treated as a minister.[4]
This IRS interpretation of “Minister of the Gospel,” includes only those persons who (a) are ordained, licensed, or commissioned, and (b) may conduct substantially all ministerial functions performed by ordained pastors.
The Broad View
Other tax courts have adopted a broader definition of “Minister of the Gospel.” These courts also require ordination, licensure, or commissioning. But under the broader scheme, these courts balance the presence or absence of each of the other ministerial functions listed above. Under this balancing test, an individual who is involved in a majority of the ministerial functions listed above, and who has the proper credentials, discussed below, will qualify as a Minister of the Gospel for housing allowance purposes.
Significantly, both narrow and broad definitions of “Minister of the Gospel” include ordination, licensure, or commissioning as a basic requirement for the classification. The IRS and the tax courts do not state specific educational or other qualifications for such credentialing to pass muster. However, the IRS and tax courts seem to require that ordination, licensure, and commissioning must convey to credentialed individuals the authority to conduct specific ministerial functions in a way, or in some measure, that non-credentialed individuals are not permitted to conduct.
Application of the Housing Allowance
In connection with confirming a clergy employee’s eligibility to claim the housing allowance, the religious or other nonprofit employer needs to approve the employee’s housing allowance for each year offered – in advance, and as a portion of his or her overall compensation. The designated housing allowance thus should be part of a minister’s salary amount, not an amount in addition to such salary amount. As described in the following paragraphs, such allocated allowance must constitute compensation for ministerial services, be used to pay housing expenses, and must not exceed the fair rental value of the minister’s home, including furnishings and the cost of utilities.
Designating a Ministerial Housing Allowance
An employer’s governing body[5] must approve a specific dollar amount as a housing allowance and record the designation in writing in advance of the calendar year in which the minister plans to claim the housing allowance. An employer that fails to designate an allowance in advance of a calendar year should do so as soon as possible, but the housing allowance will only operate prospectively. Keep in mind, since an organization’s fiscal year may not align with the calendar year, it may be beneficial to mark an appropriate date in advance that the organizational board and religious leader annually coordinate the housing allowance amount for their respective budgets.
Note too that an approved housing allowance may provide as well for future years. For example, a legally effective board resolution today could provide as follows: “The Board hereby approves a housing allowance of $____________ for Pastor Joe, as a portion within his overall $______________ annual salary, to be effective for tax year 2023 and therefore, and will have a 3% increase for each year following 2023.”
When the employer identifies an appropriate housing allowance, the governing board thus should prepare a written resolution to approve the amount. The resolution should contain a description of the minister’s qualification for ministry as well as the ministerial services to be performed, all to optimally memorialize the clergyperson’s eligibility for the housing allowance. Additionally, the resolution should specify the minister’s total annual compensation as well as the designated housing allowance. The employer may further wish to include in the resolution a percentage increase to account for yearly increases in income and the housing allowance, as indicated above.
Designating a Housing Allowance Amount
Per applicable IRS requirements, the nontaxable portion of a designated housing allowance (i.e., what a minister is actually allowed to claim on his or her taxes) cannot exceed the lowest of:
a. the minister’s actual housing expenses for the year;
b. the annual rental value of the minister’s home (furnished, plus utilities); or
c. the employer-designated housing allowance.
Consequently, it may be quite important for an employer to designate a generous housing allowance. For example, consider a clergyperson earning $80,000 per year, of which $10,000 is designated as a housing allowance but who incurs $17,000 in actual housing expenses in the specified year. Per (c) above, the clergyperson could claim only $10,000 for the housing allowance - i.e., subject to income tax on $70,000 in compensation. (Correspondingly, the employer’s budgeted annual salary for this clergyperson should be $80,000, which includes the designated $10,000 housing allowance.) But if the employer were to designate $20,000 (of the total $80,000 annual salary), then the clergyperson could claim $17,000 – i.e., the amount of actual housing expenses (assuming that $17,000 is lower than then rental value, per (b) above). In the latter case, the clergyperson would be subject to income taxes on only $63,000 of his or her $80,000 annual salary – even though the employer has designated a larger housing allowance amount.
To determine the appropriate amounts per (a) and (b) above, ministers should identify all amounts necessary to maintain their residences. The following are typical expense categories relevant to these aspects of the housing allowance determination:
• Down payment on purchased home;
• Mortgage payments (including principle and interest);
• Real estate taxes;
• Rental payments;
• Utilities (including water, gas, electric, sewer, telephone, cable, non-business internet);
• Property insurance;
• Home repairs and maintenance (including pest control, roof replacement, appliance repair, carpet cleaning);
• Furnishings and appliances (purchase and repair);
• Yard maintenance and repairs; and
• Homeowners’ association dues.
The minister could submit this total amount to the employer as a principled basis for the proposed housing allowance for the coming year, and properly generous too. Note further that IRS guidance does not mandate a certain standard of living. So long as the minister’s housing allowance does not exceed actual housing expenses or the annual rental value of their home, employers may designate an amount they deem appropriate for the area’s cost of living and in alignment with the minister’s overall compensation.
With these considerations in mind, it is better to estimate housing expenses too high than too low. Moreover, if a change in living circumstances associated with a higher cost of living is anticipated during the coming year, it is advisable to designate a more generous amount than based on prior actual housing costs or fair rental value of the minister’s home (furnished and with utilities). Of prime importance, no tax penalty exists for overestimating housing costs and designating a housing allowance that is ultimately higher than actual housing expenses or the fair rental value calculation. Consequently, if the housing allowance amount designated in advance exceeds the legally proper limit (e.g., actual housing expenses for the subject year or the fair rental value), then the minister should limit his or her claimed housing allowance exclusion from taxable income accordingly.[6]
Percentage Limits of Compensation for Housing Allowances
Does any percentage limit apply to a minister’s housing allowance? In short – no. But with a dose of healthy caution.
More specifically, up to 100% of a minister’s annual compensation may be designated as a housing allowance. In some instances, designating a minister’s entire salary as a housing allowance may be entirely appropriate. For example, if a minister is earning “mission” pay of $25,000 annually, designating 100% of his or her annual compensation as a housing allowance would not be unreasonable. Indeed, a minister could well be expected to spend $25,000 annually on housing, especially if he or she lives in an expensive urban area like New York City or San Francisco.
In contrast, however, the same 100% designation would not appear so reasonable if the pastor’s annual compensation were $300,000. Nothing is to be gained by proposing and designating an allowance so significantly above the maximum authorized amount, that is (per above), the least of: (a) the minister’s actual housing expenses for the year; (b) the amount officially designated as the housing allowance; or (c) the fair rental value of the home, including furnishings, utilities, etc. Indeed, making such a high-dollar designation may lead to confusion (such as that the specific designation may be claimed by the minister, instead of the lesser applicable amount) or, at worst, invite unwanted IRS scrutiny of the housing allowance’s legitimacy.[7] It thus would be much better in such a situation, practically and legally, to designate a more realistic housing allowance (albeit generous) based on the above-listed expense categories.
Ministerial Reporting and Record-Keeping for Housing Allowances
As noted above, a minister's housing allowance is excludable from gross income (per the above limitations on actual expenses, designated allowance, or fair rental value) for income tax purposes but not for self-employment tax purposes. This means that federal and state income taxes are directly reduced because the housing allowance will reduce the minister's taxable income. But self-employment taxes (i.e., social security/Medicare) are not affected at all by the housing allowance.
For tax reporting purposes, the employer is not required to report the designated housing allowance on the minister’s W-2 but should report the amount in Box 14 (“Other”) of the W-2 and should otherwise identify the amount in writing (as described above). The minister, in turn, will report the amount designated as the housing allowance on Schedule SE of his or her federal tax return, and the minister will pay social security/Medicare tax (self-employment tax) on the income (unless the minister has applied for, and the IRS has approved, an exemption from social security taxes). As part of clergy tax compliance, the minister thus should carefully determine whether he or she receives any compensation designated in advance as a housing allowance but subject to income taxes – that is, more than both actual housing expenses and the fair rental value (as described above). In that event, the minister should modify reportable and taxable income accordingly, as reflected on his or her IRS Form 1040, Individual Income Tax Return.
Particularly to take maximum advantage of the housing allowance income tax benefit, clergy members should retain original receipts of all housing expenses paid during the year. Invoices, canceled checks, and credit card receipts may also be used to substantiate housing expenses. Ministers should track expenses throughout the calendar year, for the additional benefit of providing helpful information for future years’ housing allowance designations.
Concluding Remarks
Ministry service can come with significant sacrifices of time, finances, and other resources. Making the most of available clergy tax benefits like the housing allowance is fiscally smart, but it may involve some careful upfront evaluation for eligibility as well as conscientious follow-through for advance approval, periodic updates to designated amounts, and responsible record-keeping and reporting. Take care to consider the benefit a housing allowance can provide for ministerial staff – particularly those whose annual wages would not otherwise allow them to live and do ministry within the organization’s community. Responsible attentiveness to the above areas should provide a strong basis upon which to determine and designate appropriate housing allowances.
[1] Note that the housing-related exclusion is for purposes of income tax, for which clergy may be treated as employees of their employers. On the other hand, clergy are uniformly treated as self-employed – regardless of their work status or responsibilities – in terms of Social Security and Medicare taxes. They thus are legally responsible for the full 15.3% of wages paid (including any amount allocated to a housing or parsonage allowance) of such taxes, although in other contexts employees pay 7.65% and employers pay the other 7.65%. For more information, please see IRS Topic No. 417 Earnings for Clergy and IRS Publication 517.
[2] For more information on the Seventh Circuit’s landmark Gaylor ruling, please see our law firm’s blog articles, Seventh Circuit: Clergy Housing Allowance is Constitutional and “Play Between Joints” and Tax Theory: Reflections on Seventh Circuit’s Clergy Housing Allowance Ruling.
[3] Although religious leaders abound in numerous types and titles, the IRS uses the term “Minister of the Gospel.” For purposes of this article, the word “minister” and “clergy” are used throughout this article to identify a religious leader who may qualify for the housing allowance tax benefit.
[4] IRS Publication 517, p. 3.
[5] Typically, the governing body is the organization’s board, but sometimes it is a congregation – as identified in the organization’s bylaws or other governing document.
[6] Assuming a change of living circumstances, it is possible that a housing allowance could be increased mid-year, such as to accommodate a move to a location with a higher cost of living. Any change in the housing amount previously designated must be adopted by the employer, recorded in writing, and designated in advance. A change so designated will only apply prospectively.
[7] See, e.g., Warren v. Commissioner of Internal Revenue (addressing the IRS’s notice of deficiency issued to well-known Pastor Rick Warren, and asserting that his claimed $80,000 housing allowance was excessive), and its related tax case particularly the dissenting opinion focusing on potential for abuse.
