What can be included as part of the housing allowance?
Article summary. A minister sells a home and uses the “gain” as a down payment on a new home. Can the minister include the down payment as a housing expense when computing the nontaxable portion of the housing allowance at the end of the year? Or is the minister prevented from doing so because the down payment was paid out of the gain from the sale of the former home rather than out of the housing allowance? These are common questions that often confront ministers at the time they sell a home and purchase a new home. This article will address these questions based on the most recent precedent.
Can ministers use the net “gain” from the sale of a home to pay the down payment on a new home and claim the down payment as a housing expense in computing the nontaxable portion of their housing allowance? Or are ministers prohibited from applying their housing allowance to the down payment because it was paid out of the gain from the sale of the former home rather than out of the housing allowance? This question may arise not only when ministers sell their home and apply some or all of the net gain toward the purchase price of a new home, but also when they buy a new home before selling the former home, and apply some or all of the gain from the sale of the former home to the mortgage loan on the new home. The tax consequences can be considerable if the amount of the net gain applied to the down payment or prepayment of a mortgage loan is substantial. Let’s illustrate this relatively common question with a few examples.
• Example. Pastor G had his church designate his entire 2001 salary of $40,000 as a housing allowance in anticipation of selling his current home and buying a new one that year. He buys a new home in May of 2001 for $100,000 with a $10,000 down payment and a $90,000 mortgage loan. In June of 2001 he sells his former home for $80,000, pays off his mortgage loan of $50,000, and uses the remaining $30,000 to pay down the mortgage loan on the new home. During 2001 Pastor G incurs an additional $10,000 of housing expenses consisting of monthly payments on the mortgage loan on the new home, utilities, home insurance, property taxes, and miscellaneous repairs. Pastor G does not report any taxable income (for income tax reporting purposes) on his Form 1040 for 2001 since his housing expenses (including the use of some of the sales proceeds from the sale of his former home to pay down the mortgage loan on his new home) exceed his housing allowance.
• Example. Same facts as the previous example, except that Pastor G sold his home in May for $80,000, pays off his mortgage loan of $50,000, and deposits the remaining $30,000 in his bank account. In June, Pastor G buys a new home for $100,000 and uses the entire $30,000 “gain” from the sale of his former home as a down payment on the new home. Pastor G does not report any taxable income (for income tax reporting purposes) on his Form 1040 for 2001 since his housing expenses (including the use of some of the sales proceeds from the sale of his former home to pay down the mortgage loan on his new home) exceed his housing allowance.
Has Pastor G correctly reported his taxable income in both examples? Is the nontaxable portion of his housing allowance in both examples $40,000 (the full amount designated by the church), or some lesser amount? In other words, can he apply his housing allowance to housing expenses he paid with proceeds from the sale of his former home? That is the question addressed in this article.
The Marine Case (1967)
In 1967, the Tax Court addressed the question of whether a pastor can apply his housing allowance to housing expenses paid out of the gain from the sale of his former home. Marine v. Commissioner, 47 T.C. 609 (1963).
Facts
On January 1, 1963, a church’s board of trustees adopted the following resolution:
For the year 1963 and thereafter unless modified, all payments to Pastor Fred are to be considered rental allowance unless the payments exceed $20,000.
During 1963 Pastor Fred received compensation of $13,500 from the church. In July of 1963, Pastor Fred purchased a new home for $18,500. He made a cash deposit of $500 on the property at the time of signing the contract of sale. The balance was provided by a 1-year mortgage loan of $18,000 which Pastor Fred received from a local bank.
In August of 1963, Pastor Fred sold his former home for $16,500. Of this amount, $15,000 was withheld from Pastor Fred at closing and paid over to his bank in partial satisfaction of the $18,000 mortgage loan. Pastor Fred paid an additional $3,000 in expenses associated with the ownership of his home in 1963 (monthly mortgage payments, utilities, furnishings, insurance, property taxes).
In preparing his federal income tax return for 1963, Pastor Fred did not report any taxable income. He assumed that his entire salary of $13,500 was nontaxable since the church had designated this entire amount as a housing allowance and he incurred housing expenses well in excess of this amount. The IRS audited Pastor Fred and determined that the housing allowance could be applied only to the $3,000 that he paid out of his own funds for housing expenses in 1963. But it refused to allow Pastor Fred to apply his housing allowance to the $15,000 gain from the sale of his former home that was used to pay down the mortgage loan on his new home. Pastor Fred appealed to the Tax Court.
The Tax Court’s Decision
The Tax Court agreed with the IRS that Pastor Fred could only apply his housing allowance to the $3,000 of out-of-pocket housing expenses that he incurred in 1963. The court noted that the tax code originally only allowed ministers to exclude from taxable income the annual rental value of a parsonage. In 1954, the code was amended to allow ministers to exclude the portion of their income designated by their employing church as a housing allowance to the extent it is used to pay for housing expenses. The reason for the 1954 amendment, noted the court, was to eliminate the prior law’s discrimination against ministers who were not provided with a parsonage and who had to use their own income to provide a home. As a result, in enacting the 1954 code, “Congress not only continued to provide that the rental value of a house furnished to a minister would not be included in gross income, but also added a further provision that a rental allowance paid to a minister as part of his compensation was excludable from gross income to the extent used by him to rent or provide a home.”
The purpose of the 1954 amendment was made clear by the congressional committees that proposed its enactment. For example, one committee report states,
Under present law, the rental value of a home furnished a minister of the gospel as a part of his salary is not included in his gross income. This is unfair to those ministers who are not furnished a parsonage, but who receive larger salaries (which are taxable) to compensate them for expenses they incur in supplying their own home. Both the house and your committee has removed the discrimination in existing law by providing that the present exclusion is to apply to rental allowances paid to ministers to the extent used by them to rent or provide a home.
The court concluded,
Plainly, the purpose of the new provision was to equalize the situation between those ministers who received a house rent free and those who were given an allowance that was actually used to provide a home. There certainly does not appear to be any intention to place ministers of the second category in a favored position. Yet, if Pastor Fred were to prevail here, his entire compensation for 1963 would escape taxation, a result that seems clearly contrary to the underlying purpose of the statute. And the words of the statute itself explicitly preclude that result, for it provides that the rental allowance is excludable from a minister’s gross income only “to the extent used by him to rent or provide a home.” The circumstance that Pastor Fred’s entire compensation was artificially designated as a rental allowance pursuant to the statement signed by the board of trustees of the church cannot in fact convert into a rental allowance that which was plainly compensation for services, nor does it appear on this record that to the extent that the IRS refused to treat his compensation as an excludable rental allowance such compensation was actually “used by him to rent or provide a home.” On the facts before us Pastor Fred did not use his entire 1963 compensation of $13,500 to rent or provide a home. True, he purchased a new residence in 1963 at a price which exceeded that amount. But the great bulk of that price was paid out of the proceeds of sale of his old residence.
The reasoning of the Tax Court in the Marine case can be summarized as follows:
(1) Prior to 1954, the tax code only allowed a tax benefit to ministers who lived in a church-owned parsonage (the annual rental value of the parsonage was nontaxable in computing income taxes).
(2) This provision “discriminated” against ministers who owned or rented their homes, since they received no comparable tax benefit.
(3) To eliminate this “discrimination” the tax code was amended in 1954 to allow ministers who do not live in parsonages to exclude from taxable income in computing their income taxes the portion of their ministerial compensation designated in advance as a housing allowance by their employing church, to the extent it is used for housing expenses.
(4) The 1954 amendment was designed to provide homeowning ministers with a comparable tax benefit to that enjoyed by ministers who live in church-owned parsonages, not a greater tax benefit.
(5) Allowing ministers to reduce taxable income to zero by having their entire salary designated as a housing allowance and then incurring housing expenses of this much or more would violate the purpose of the 1954 amendment by providing these ministers with a greater tax benefit than what is available to ministers who live in parsonages.
(6) A housing allowance is nontaxable in computing federal income taxes only if it is designated out of compensation earned by a minister from the exercise of ministry and is used “to rent or provide a home.” A housing allowance cannot be applied to proceeds from the sale of a home that are withheld from a minister at closing and applied directly to the purchase price, or mortgage loan, on a new home since these proceeds are not compensation received from ministry.
• Key point. The Marine case was a “regular” Tax Court decision. This means that it was a decision by the full court. Such decisions have greater weight as precedent than “memorandum” decisions by individual Tax Court judges.
Critique
The court’s decision in the Marine case was based squarely on the principles of discrimination and source of income. Each principle is addressed below.
(1) Discrimination. The court concluded that allowing ministers who own their homes to have their entire salary designated as a housing allowance would violate the purpose of the 1954 tax code amendment that sought to achieve “equality” between ministers who live in parsonages and those who own or rent their home. If ministers could have all or most of their church compensation designated as a housing allowance, they would be in a “better” position than ministers who live in church-owned parsonages. But is this so? Absolutely not, for two reasons.
- First, the court completely overlooked the fact that ministers may be offered free occupancy of a parsonage as their sole compensation. While this arrangement may be rare, so is a minister who has all of his or her church compensation designated as a housing allowance. There is no “preference” in either case. Both are possible, and both do occur. In each case, the arrangement is feasible if the minister has income from another source, or if the minister’s spouse is employed and has sufficient income to support the family.
- Second, the Tax Court itself repudiated the “discrimination” basis of the Marine case in a 2000 ruling. Warren v. Commissioner, 114 T.C. 23 (2000). The Warren case is addressed below. This important case directly repudiates the “discrimination” basis of the Marine case by holding that ministers can have their entire church compensation designated as a housing allowance.
(2) Source. The court concluded that Pastor Fred’s housing allowance could not be applied to proceeds from the sale of a home that he applied to the mortgage loan on his new home since these proceeds were not compensation received for the performance of ministerial services. In other words, the “source” of funds used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. This is a correct statement. The income tax regulations specify that “in order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.” However, note that in the Marine case the $15,000 used to pay down the mortgage loan could be unequivocally traced to the proceeds from the sale of Pastor Fred’s former home because the sales proceeds were withheld from him at closing and paid directly to his bank to be applied to his mortgage loan. There was no question that the mortgage loan prepayment was paid out of the sales proceeds and not out of Pastor Fred’s church salary. Therefore, the housing allowance could not be applied to any of those proceeds. To the extent that the Marine case survives the Warren case, it is probably limited to this situation.
But what if the sales proceeds had not been withheld from Pastor Fred at closing? What if they were paid to Pastor Fred directly and he deposited them in his bank account, and later used some or all of them to make a large down payment on his new home or pay down the mortgage loan on a new home? In such a case, there would be no way to trace the $15,000 to the proceeds from the sale of Pastor Fred’s former home. The proceeds, and Pastor Fred’s church salary, would be “commingled,” making it difficult if not impossible to determine the source of the funds used to pay down the mortgage loan. It would be just as reasonable to assume that the source of the mortgage loan prepayment was Pastor Fred’s housing allowance as the proceeds from the sale of his home. There are two important qualifications to this view, however.
- Other income. This view assumes a source of income in addition to the housing allowance. If a pastor’s entire church compensation is designated as a housing allowance, and the pastor has no other source of income (including a spouse’s income), then it would be impossible to claim that the entire housing allowance should be nontaxable, even if the pastor had expenses of that much or more. After all, what income did the pastor use for living expenses? However, when a pastor has income in addition to a church salary, it makes a larger housing allowance more defensible.
- Matching expenses to income. Housing allowances are nontaxable in computing federal income taxes only to the extent they are used to pay for housing expenses. The income tax regulations specify that “a rental allowance must be included in the minister’s gross income in the taxable year in which it is received, to the extent that such allowance is not used by him during such taxable year to rent or otherwise provide a home.” Does this requirement mean that there must be a strict “matching” of housing allowances with actual housing expenses?
To illustrate, what if Pastor Fred had sold his former home in January and then used $15,000 of the proceeds to make a down payment on a new home on January 31? By January 31, Pastor Fred has received only one twelfth of his housing allowance for the year ($1,125). Can he only apply this amount to his down payment, or may he include the housing allowances he receives for the entire year ($13,500)? In other words, are housing allowances compared with housing expenses on an annual basis, or must allowances be matched with expenses on an ongoing basis throughout the year? The following arguments and precedent clearly demonstrate that any matching is done annually. Consider the following points:
(1) The IRS has never required strict matching in any ruling involving a housing allowance.
(2) The IRS does require strict matching in its audit guidelines for ministers.
(3) The IRS does not require strict matching in Publication 517 (a publication addressing tax issues for ministers).
(4) No court has ever required strict matching in any case involving a housing allowance.
(5) Ministers will almost always violate a strict matching requirement with respect to some housing expenses. To illustrate, assume that Pastor J is paid every Friday, and that he makes his monthly mortgage and utilities payments on the first day of each month. For January of 2001, the first Friday was January 5. That is the day Pastor J receives his first paycheck for the year. However, Pastor J made his mortgage and utilities payments on the first business day of the month (January 2). The important point to note is that Pastor J has received no income (or housing allowance) in 2001 when he paid the mortgage and utilities bills on January 2. He cannot “match” the payment of these housing expenses to his housing allowance. Does this mean that he cannot consider these expenses when computing the nontaxable portion of his housing allowance at the end of the year when he prepares his tax return? Neither the IRS nor any court has ever ruled that a housing allowance cannot be applied to housing expenses incurred in January (or any other month) prior to the receipt of a housing allowance of equal or greater value. The focus is on housing expenses incurred throughout the year, and whether the housing allowance designated by the church for the year is sufficient to cover these expenses. Many other examples could be given. For example, what about a minister who incurs remodeling expenses or repairs of several thousand dollars in January that are far in excess of the housing allowance distributed in that month? Again, neither the IRS nor any court has ever suggested that these expenses must be matched to the housing allowance actually paid in January. Common sense, then, indicates that strict matching of housing allowances and housing expenses is not required. Doing so would be far too impractical and would lead to absurd results. Instead, the focus is on housing expenses incurred throughout the year, and a minister’s church-designated housing allowance for the year.
(6) In 1984, the full Tax Court made the following comments about the “matching” of housing expenses to housing allowances:
Section 1.107-1(c) [of the income tax regulations] provides that, for the allowance to be excludable, the use of the allowance to rent or provide a home must be in the taxable year in which the allowance is received …. The statute and the regulation appear to require an expenditure (or conceivably some equivalent action which may constitute a use) of an amount received as compensation in the same year. Reed v. Commissioner, 82 T.C. 208 (1984).
(7) Section 1.107-1(c) of the income tax regulations specifies that “a rental allowance must be included in the minister’s gross income in the taxable year in which it is received, to the extent that such allowance is not used by him during such taxable year to rent or otherwise provide a home” (emphasis added). This language clearly applies an “annual” comparison of housing allowances to housing expenses. There is no need to “match” on a more frequent basis specific housing expenses with housing allowances actually received. So, for example, if a minister pays a monthly mortgage payment and utility bill in the first week of January before receiving his first paycheck (including housing allowance) for the year, this does not prevent him from applying his housing allowances to these expenses when computing his taxes for the year. He need not “match” housing allowances actually received to the expenses paid on a daily, weekly, or monthly basis. It is done annually.
(8) IRS Publication 517 states “if you own your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the smallest of the following: (1) The amount actually used to provide a home, (2) the amount officially designated as a rental allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.” There is no suggestion here of “matching” housing expenses to housing allowance payments. Quite to the contrary, this language clearly indicates that the housing allowance is applied to housing expenses on an annualized basis. At the end of the year, ministers determine the nontaxable portion of their housing allowance by adding up all of the housing expenses they incurred during the year. Note that the third limitation mentioned in Publication 517 (fair rental value of the home) was repudiated by the Tax Court in the Warren case discussed below.
(9) Section 461 of the tax code specifies that “the amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.”The income tax regulations specify that “generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made.” Treas. Reg. 1.461-1(c).
Revenue Ruling 71-280 (1971)
Four years after the Marine decision, the IRS ruled that the nontaxable portion of a housing allowance for ministers who own their homes can never exceed the annual rental value of the home. Revenue Ruling 71-280. The IRS based its ruling squarely on the Marine case. It concluded,
It is indicated in the Senate Report that Congress intended only to remove the discrimination in the existing law and did not intend to create a new discrimination in favor of another group by placing ministers who receive rental allowances in a better position than ministers who receive rent free homes. Consequently, a minister cannot exclude his entire compensation by the mere act of having it designated as a rental allowance. See Marine v. Commissioner, 47 T.C. 609 (1967).
As a result, ministers who own their homes can only exclude housing expenses to the extent they do not exceed either the church-designated allowance or the annual rental value of the home plus the cost of utilities. This “annual rental value” test was adopted by the IRS to eliminate any “discrimination” between ministers who live in parsonages and those who are purchasing a home.
• Key point. While no direct “matching” of housing allowances and housing expenses is required, this does not mean that housing allowances can be designated retroactively. A housing allowance must be designated in advance. This is simply another way of saying that a housing allowance is nontaxable only to the extent it is used to pay for housing expenses. This requirement cannot be met if a housing allowance is designated retroactively. In summary, while the matching of housing allowances and housing expenses is done on an annual basis, this assumes that the housing allowance was designated in advance. If a housing allowance is not designated until the middle of the year, it can be applied only to housing expenses incurred from that date through the end of the year.
The Warren Case (2000)
In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled in 2000 that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing expenses. The court threw out the “annual rental value” test that the IRS adopted in 1971. The IRS had insisted that the annual rental value test was needed to ensure that ministers who owned their homes did not receive a greater tax benefit than ministers who lived in church-owned parsonages. Ministers who live in parsonages can exclude from income the annual rental value of the parsonage, and so ministers who own their homes should not be allowed to claim a greater tax benefit than this. If their housing expenses exceed the rental value of their homes, and the nontaxable portion of their housing allowance was not limited to the rental value, then their nontaxable housing allowance could exceed the rental value, putting them in a “better” position than a minister who lives in a parsonage. In the Warren case, the Tax Court rejected this argument on the basis of three considerations.
- No prior rulings. The court noted that it had never before ruled that ministers who own their homes cannot be treated more favorably than ministers who live in parsonages.
- The annual rental value test does not ensure equality. The court noted that the annual rental value test does not eliminate unequal treatment between ministers who live in parsonages and those who provide their own homes. In fact, in some cases, ministers who provide their own homes will be treated less favorably than ministers who live in parsonages. To illustrate, if the rental value of a minister’s home is more than his actual housing expenses, the nontaxable portion of his housing allowance is limited to actual expenses. Such a minister cannot treat the annual rental value as nontaxable. This minister is treated less favorably than a minister who lives in a church-provided parsonage and who can exclude from taxable income the full annual rental value of the parsonage.
- Compliance burden. The court noted that if it retained the annual rental value test, then ministers who provide their own housing would face a “compliance burden” not imposed on ministers who live in parsonages. Ministers who provide their own housing
could be required to obtain an estimate of the rental value of their home every year in order to know how much to exclude …. This burden is not imposed on ministers for whom homes are provided, the rental value of which is excludable … because they may simply exclude the value of the home without any need to estimate the rental value. In the instant case, the parties stipulated the rental value for each year. However, the burden of obtaining valuation estimates could become onerous where rental value is in dispute. We decline to endorse this disparate treatment here by imposing potentially burdensome valuation obligations where neither the statute nor the legislative history so requires.
Reconciling The Marine And Warren Cases
In the Marine case (1967) the Tax Court ruled that a minister could not have all his church compensation designated as a housing allowance and then apply the allowance to proceeds from the sale of a home that were withheld at closing and paid directly to his bank to reduce the mortgage loan on his new home. This conclusion was based on two grounds: (1) preventing ministers who own their homes to claim a greater tax benefit than ministers who live in parsonages (the “discrimination” ground); and (2) limiting the housing allowance to compensation received by a minister for services performed in the exercise of ministry (the “source” ground).
In the Warren case (2000) the Tax Court repudiated the first of the two grounds it had relied on in the Marine case. The court concluded that all of a minister’s church compensation can be designated as a housing allowance, and this entire amount is nontaxable in computing federal income taxes if the minister has housing expenses of this much or more. This leaves the “source” ground as the only remaining basis for the Marine decision. That is, the “source” of funds used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. But it must be emphasized that this is a narrow ground, since in the Marine case the $15,000 used to pay down the mortgage loan unequivocally could be traced to the proceeds from the sale of Pastor Fred’s former home because the sales proceeds were withheld from him at closing and paid directly to his bank to be applied to his mortgage loan. There was no question that the mortgage loan prepayment was paid of the sales proceeds and not out of Pastor Fred’s housing allowance. Therefore, the housing allowance could not be applied to any of those proceeds. To the extent that the Marine case survives the Warren case, it is probably limited to this situation. This conclusion is supported by the following reference to the Marine case in the Warren ruling:
a taxpayer who received $13,500 compensation as a minister, sold a house and used the proceeds to buy another house. As a result of his use of the proceeds of the sale of the first house to buy the second house, we found that he “used” only $3,000 of his $13,500 compensation for housing.
• Key point. The Warren case was a “regular” Tax Court decision. This means that it was a decision by the full court. Such decisions have greater weight as precedent than “memorandum” decisions by individual Tax Court judges.
• Key point. The IRS has appealed the Warren case. If a federal appeals court, or the United States Supreme Court, reverses the Tax Court’s decision then the housing allowance exclusion for homeowning ministers once again will not be allowed to exceed the annual rental value of the minister’s home.
Examples
Let’s illustrate the above analysis with several examples.
• Example 1. Pastor G had his church designate his entire 2001 salary of $40,000 as a housing allowance in anticipation of selling his current home and buying a new one that year. He buys a new home in May of 2001 for $100,000 with a $10,000 down payment and a $90,000 mortgage loan. In December of 2001 he sold his former home for $80,000. At closing, the sales proceeds are used to pay off Pastor G’s mortgage loan of $50,000, and the remaining $30,000 are withheld and sent directly to Pastor G’s bank to pay down the mortgage loan on his new home. During 2001 Pastor G incurs an additional $10,000 of housing expenses, consisting of monthly payments on the mortgage loan on the new home, utilities, home insurance, property taxes, and miscellaneous repairs. Assume that the annual rental value of each home (including utilities) is $15,000. What is the nontaxable portion of Pastor G’s housing allowance? Consider the following analysis: (1) According to the Marine case, the nontaxable portion of the housing allowance would be $10,000, representing his housing expenses that were paid out of his housing allowance. (2) According to the Warren case, the nontaxable portion of the housing allowance would be $10,000. While the Tax Court in the Warren case rejected the holding of the Marine case and Revenue Ruling 71-280 that housing allowances can never provide a greater tax benefit to ministers who own their homes than is available to ministers who live in parsonages, it did not disturb the Marine case’s conclusion that the “source” of a housing allowance used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. This conclusion is supported by the income tax regulations, which specify that “in order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.” In this example, the $30,000 used to pay down the mortgage loan can be unequivocally traced to the proceeds from the sale of Pastor G’s former home because the sales proceeds were withheld from him at closing and paid directly to his bank to be applied to his mortgage loan. There is no question that the mortgage loan prepayment was paid out of the sales proceeds and not out of Pastor G’s church salary. Therefore, the housing allowance could not be applied to any of those proceeds. (3) If the Warren case is overruled on appeal, or through legislation, this would not affect the analysis in this example.
• Example 2. Same facts as example 1, except that at the closing of the sale of Pastor G’s former home the escrow agent withholds the net sales proceeds of $30,000 and applies it to the down payment on the new home. The same analysis in example 1 would apply.
• Example 3. Same facts as example 1, except that at the closing of the sale of Pastor G’s former home the sales proceeds are distributed as follows: $50,000 is used to pay off the remaining mortgage loan on the former home, and the balance of $30,000 is distributed directly to Pastor G. Pastor G later uses the entire $30,000 as a down payment on the purchase of his new home. What is the nontaxable portion of Pastor G’s housing allowance? Consider the following: (1) According to the Marine case, the nontaxable portion of the housing allowance would be $10,000, representing his housing expenses that were paid out of his housing allowance. (2) According to the Warren case, the nontaxable portion of the housing allowance would be $40,000. The Tax Court in the Warren case rejected the holding of the Marine case and Revenue Ruling 71-280 that housing allowances can never provide a greater tax benefit to ministers who own their homes than is available to ministers who live in parsonages. Therefore, the nontaxable portion of Pastor G’s housing allowance is not limited to the annual rental value of his home. The Tax Court in the Warren case did not disturb the Marine case’s conclusion that the “source” of a housing allowance used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. This conclusion is supported by the income tax regulations, which specify that “in order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.” Unlike examples 1 and 2, the $30,000 used by Pastor G for the down payment on his new home cannot be traced to the proceeds from the sale of the former home because the sales proceeds were simply distributed to him and “commingled” with his church compensation (and housing allowance) making it difficult if not impossible to determine the source of the funds used for the down payment. It would be just as reasonable to assume that the source of the down payment was Pastor G’s housing allowance as the proceeds from the sale of his former home. (3) If the Warren case is overruled on appeal, or through legislation, this would affect the analysis in this example. The nontaxable portion of Pastor G’s housing allowance could not exceed the annual rental value of his home, including utilities. Therefore, only $15,000 of the housing allowance would be nontaxable.
• Example 4. Same facts as example 3, except that Pastor G sells his home on June 30, 2001. The same analysis in example 3 would apply. As noted above, Pastor G’s housing allowance distributions do not have to “match” housing expenses on a weekly or monthly basis. Rather, at the end of the year, the nontaxable portion of the housing allowance cannot exceed housing expenses incurred during the year. The fact that Pastor G made a down payment half way through the year of $30,000, though at that time he had received only half of his housing allowance ($20,000), does not mean that he is prohibited from including the entire down payment among his housing expenses when computing the nontaxable portion of his housing allowance at the end of the year.
• Example 5. M is a retired minister who rents a home. In December of 2000 she informs her denominational pension board that she wants a lump sum distribution from her account of $100,000 in 2001, and she wants the entire distribution to be designated as a housing allowance. M uses the distribution as a down payment on a new home in July of 2001. She pays her living expenses with social security benefits and investment income. Assume that the rental value of the new home is $12,000 for the months that it is occupied by M. What is the nontaxable portion of M’s housing allowance? Consider the following: (1) According to the Marine case, the nontaxable portion of the housing allowance would probably be limited to the rental value of the home for the months M occupied it in 2001 ($12,000). This is the same result dictated by Revenue Ruling 71-280 and IRS Publication 517. (2) According to the Warren case, the nontaxable portion of the housing allowance would be the full $100,000. The Tax Court in the Warren case rejected the holding of the Marine case and Revenue Ruling 71-280 that housing allowances can never provide a greater tax benefit to ministers who own their homes than is available to ministers who live in parsonages. (3) If the Warren case is overruled on appeal, or through legislation, this would affect the analysis in this example. The nontaxable portion of M’s housing allowance could not exceed the annual rental value of her home, including utilities. Therefore, only $12,000 of the housing allowance would be nontaxable.
• Example 6. A church board is considering the year 2002 compensation package for Pastor B. It decides on total compensation of $30,000. Pastor B informs the board that he will have ordinary housing expenses of $10,000, but that he also will be incurring remodeling expenses of an additional $10,000 during 2002. The board is uncomfortable designating two-thirds of Pastor B’s total compensation as a housing allowance. According to the Tax Court’s decision in the Warren case, the board is free to designate two-thirds of the pastor’s compensation as a housing allowance. The fact that this will exceed the annual rental value of the home (and violate the holding of the Marine case, Revenue Ruling 71-280, and IRS Publication 517) is irrelevant. However, if the Warren case is overruled on appeal, or through legislation, this would affect the analysis in this example. The nontaxable portion of Pastor B’s housing allowance could not exceed the annual rental value of his home, including utilities.
• Example 7. Pastor H is a part-time associate pastor at his church. The church board plans to pay him $10,000 for 2002. Pastor H asks the board to designate 100 percent of this amount as a housing allowance. The church treasurer is uncomfortable designating the entire amount as a housing allowance. According to the Tax Court’s decision in the Warren case, the board is free to designate all Pastor H’s compensation as a housing allowance. This violates the first basis of the Marine case since designating 100% of a pastor’s compensation as a housing allowance puts him in a better position than a pastor who lives in a parsonage. However, the Tax Court repudiated this aspect of the Marine case in the Warren ruling in 2000. The Tax Court in the Warren case did not disturb the Marine case’s conclusion that the “source” of a housing allowance used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. This conclusion is supported by the income tax regulations, which specify that “in order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.” In this example, the full $10,000 used by Pastor H to pay for housing expenses can be allocated to his housing allowance. If the Warren case is overruled on appeal, or through legislation, this might affect the analysis in this example. The nontaxable portion of Pastor H’s housing allowance could not exceed the annual rental value of his home, including utilities.
• Example 8. A church board is considering the year 2002 compensation package for Pastor N. It decides on total compensation of $60,000. Pastor N asks the board to designate this entire amount as a housing allowance. He informs the board that he will have ordinary housing expenses of $15,000, but that he also will be purchasing a new home in 2002 and plans on making a large down payment (with the sale proceeds from his prior residence) of $45,000. Pastor N’s spouse is employed as a college professor, and the couple plans on using her salary for living expenses in 2002. Pastor N later uses the entire $60,000 to pay for housing expenses in 2002. Assume that the rental value (including utilities) of the former and new homes, during the months that Pastor N occupies them, is $12,000. What is the nontaxable portion of Pastor N’s housing allowance? Consider the following: (1) According to the Marine case, Revenue Ruling 71-280, and IRS Publication 517, the nontaxable portion of the housing allowance would be $12,000, the rental value of the homes during his occupancy. (2) According to the Warren case, the nontaxable portion of the housing allowance would be $60,000. The Tax Court in the Warren case rejected the holding of the Marine case and Revenue Ruling 71-280 that housing allowances can never provide a greater tax benefit to ministers who own their homes than is available to ministers who live in parsonages. Therefore, the nontaxable portion of Pastor N’s housing allowance is not limited to the annual rental value of his home. The Tax Court in the Warren case did not disturb the Marine case’s conclusion that the “source” of a housing allowance used to pay for a minister’s housing expenses must be compensation earned by the minister in the exercise of ministry. This conclusion is supported by the income tax regulations, which specify that “in order to qualify for the exclusion, the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel.” However, in this example Pastor N’s housing expenses can be allocated to his housing allowance. This example is not like the Marine case, in which proceeds from the sale of a home were withheld from Pastor Fred and paid directly to his bank to reduce the mortgage loan on his new home. In that case, there was a legitimate argument that Pastor Fred’s housing expenses were not being paid out of his housing allowance. But this argument cannot be made in this example since there was no contractual arrangement directing that housing expenses be paid out of a source other than a housing allowance. (3) If the Warren case is overruled on appeal, or through legislation, this would affect the analysis in this example. The nontaxable portion of Pastor N’s housing allowance could not exceed the annual rental value of his home, including utilities. Therefore, only $12,000 of the housing allowance would be nontaxable.
Impact On Retirement Contribution Limits
This article has addressed the computation of housing allowances. Note, however, that this issue must be viewed in a broader context. Relying on the Warren case may affect a minister’s allowable contributions to a “403(b)” retirement account (sometimes called a “tax-sheltered annuity”). In general, the maximum amount of tax-deferred contributions to a 403(b) retirement account is based on a minister’s total compensation. If total compensation is reduced by a larger housing allowance, then this may lower the amount that can be legally contributed to such a retirement account. For example, one of the limits that applies to contributions to a 403(b) plan is the so-called “exclusion allowance.” This limit is computed by multiplying 20% times an employee’s years of service times “includible compensation” and then less all prior tax-deferred contributions. For purposes of the exclusion allowance, includible compensation does not include the housing allowance. As a result, a larger housing allowance allowed by the Warren case will lower this limit and may result in lower allowable contributions to a 403(b) account.
Should ministers whose nontaxable housing allowance was limited by the annual rental value test in any of the previous three years file an amended return to claim a larger housing allowance exclusion? While this is an option, keep in mind the following two considerations: (1) If the Warren case is reversed on appeal, then the filing of amended returns based on that case will expose a minister to additional taxes and interest. (2) If the Warren case is affirmed on appeal, then a minister who files amended tax returns claiming larger housing allowances for one or more of the previous three years may affect the amount that can be contributed to his or her 403(b) retirement account. In some cases, the increased housing allowances will reduce taxable income enough to place retirement contributions over the legal limit.
In summary, ministers should carefully consider both the advantages and disadvantages of relying on the Warren case. If the case is eventually affirmed on appeal, and Congress does not change the law, then the Warren case will assist those ministers who incur housing expenses in excess of the annual rental value of their homes. However, ministers should be sure to consider the impact that a larger housing allowance will have on their retirement contributions.
© Copyright 2001 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m96 m94 m27 c0301
