Background. Section 107 of the tax code states that “in the case of a minister of the gospel, gross income does not include … the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” This language requires very little explanation. The portion of a minister’s church-designated housing allowance that is used to pay for housing-related expenses is nontaxable for federal income tax reporting purposes. Stated differently, ministers may exclude from taxable income the lesser of (1) the church-designated housing allowance, or (2) the actual amount of housing-related expenses paid during the year.
Unfortunately, in 1971 the IRS imposed an additional limitation on ministers who own their homes—the nontaxable portion of a church-designated housing allowance may not exceed the annual fair rental value of the minister’s home (furnished, plus utilities). Revenue Ruling 71-280. As a result, a housing allowance is nontaxable only to the extent that it is used to pay for housing expenses and does not exceed the annual fair rental value of the minister’s home (furnished, plus utilities). The main objective of the fair rental value limit was to prevent ministers who own their homes from receiving a greater tax benefit than those who live in a church-provided parsonage.
The Warren case. 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-related expenses. Warren v. Commissioner, 114 T.C. 23 (2000). The court threw out the annual “fair rental value” test the IRS adopted in 1971. The IRS appealed the Warren case to the ninth circuit federal court of appeals in California. In March of 2002 a three-judge panel of the court asked the parties, and Professor Erwin Chemerinsky of the University of Southern California Law School, to submit additional briefs to the court addressing the constitutionality of the housing allowance under the first amendment’s nonestablishment of religion clause. The court’s order left little doubt that it was going to rule that the housing allowance is unconstitutional.
Congress responds. In response to this threat to the housing allowance, the “Clergy Housing Allowance Clarification Act of 2002” was unanimously passed by both houses of Congress and signed into law the President in May. The Act had one purpose—to amend the tax code to reinstate the annual fair rental value limit on ministers’ housing allowances so that the IRS would dismiss its appeal of the Warren case and deprive the federal appeals court of the opportunity to address the constitutionality of the housing allowance on its own initiative.
The new law had the desired effect. The IRS agreed to dismiss the appeal of the Warren case, and, on August 26, 2002, the federal appeals court issued an order formally dismissing the case. This order was delayed for several months while the court considered a motion by Professor Chemerinsky (whom the court had appointed earlier in the year to submit a brief addressing the constitutionality of the housing allowance) to intervene in the case as a party. Chemerinsky let it be known that if he was permitted to intervene in the case as a party, he would not agree to dismiss the case and would ask the court to rule that the housing allowance was unconstitutional. The court denied Chemerinsky’s motion to intervene, and this effectively ended the case.
Key point. The court noted that Chemerinsky was free to file a new lawsuit in a federal district court, as a taxpayer, challenging the constitutionality of the housing allowance. It remains to be seen if such a challenge will be launched.
Relevance to church treasurers. The tax code now limits the nontaxable portion of a church-designated housing allowance for ministers who own their home to the annual fair rental value of the home (furnished, plus utilities), beginning in 2002. As a result, ministers who own their home will not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance, to the extent that the allowance represents compensation for ministerial services, is used to pay housing expenses, and does not exceed the annual fair rental value of the home (furnished, plus utilities). Housing related expenses include such items as mortgage payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance.
The fair rental value limit will not apply to pre-2002 returns, with two exceptions: (1) ministers who applied the fair rental value limit in computing their taxes for 2000 or 2001 cannot submit an amended return for either year recomputing their taxes without reference to the fair rental value limit; and (2) ministers who received an extension of time to file their 2001 tax return (until August 15, 2002) must apply the fair rental value limit in computing their 2001 taxes.
Key point. Church treasurers and church boards should keep the fair rental value limit in mind when designating housing allowances in the future. There is nothing to be gained by designating housing allowances (for ministers who own their home) that are significantly above the annual fair rental value of the home.
This article first appeared in Church Treasurer Alert, October 2002.