Housing Allowances: Expanded Benefits and Planning Opportunities

I n Warren, 114 TC No. 23, the Tax Court intervened in a long-standing IRS policy that had capped ministers' housing allowances (MHAs) at the rental value of the home. Under this decision, all amounts designated as an MHA and used by a minister to provide a home may be excluded from income. Many ministers will experience significant tax savings if they satisfy some relatively easy and familiar requirements.

Housing Allowances

Since 1939, ministers have been allowed to exclude from income the value of a home or parsonage provided for them. In 1954, Congress moved to end the discrimination against ministers who receive an MHA and buy their own homes. Sec. 107 allows a minister to exclude from income the "allowance paid to him as part of his compensation, to the extent used by him to provide a home."

An MHA is an exclusion from income, not a deduction. This is money the church pays the minister that does not have to be reported as income. However, the portion of the MHA used to pay mortgage interest and real property taxes is deductible as an itemized deduction on Schedule A. These deductions create the possibility of a double tax benefit. In addition, recent legislation prevents the gain from a home sale from ever being taxed, unless the gain exceeds $500,000 ($250,000 on a single return) or a home is sold more often than every two years. The combination of these three benefits (income exclusion, itemized deductions and gain-on-sale exclusion) make a minister's home the perfect tax shelter. This shelter will even survive the minister; heirs can use as their tax basis the value of the home at the time of the minister's death.

Although the MHA is a wonderful income tax shelter, it does not shelter income from Social Security taxes; the minister must pay Social Security taxes on his MHA.

Amount of the MHA

For years, the Service's official position has been that the amount excluded from income is the smallest of the following:

1. The amount used to provide a home, i.e., the total of actual housing expenses, including mortgage payments or rent, taxes, insurance, furnishings, repairs, improvements and utilities (including garbage pickup and local telephone).

2. The amount officially designated by the church.

3. The fair rental value of the home, including utilities and furnishings.

Warren

Dr. Warren was minister of the Saddleback Valley Community Church in California. In the years at issue, the church designated all (or virtually all) of Dr. Warren's compensation as an MHA. (He was able to spend virtually his total compensation on housing, because he had substantial extra income from a tape and book ministry.) He excluded from income the total of all amounts spent on his home. The IRS audited his return, limited his exclusion to the home's rental value and assessed additional taxes on the excess.

The Service's position that a rental value limit should be applied was based primarily on two arguments. First, Sec. 107, which allows an exclusion for both parsonages and MHAs, includes the words "rental value" in the heading. Second, the IRS contended that the original Congressional intent in allowing the MHA was to put parsonage dwellers and MHA recipients on equal footing. Allowing an MHA exclusion in an amount greater than the fair rental value would give a larger tax benefit to MHA recipients.

The Tax Court took the position that the subsection containing the parsonage exclusion and the subsection containing the MHA exclusion should be interpreted separately. Because the MHA subsection does not mention "rental value," the Tax Court refused to carry over the rental value limit from the parsonage subsection. In effect, the court held that Congress should have explicitly inserted a rental value limit in the MHA subsection if one had been intended.

If the Service chooses to appeal this decision, it will be interesting to see how an appellate court views this reasoning. In the meantime, ministers have substantial authority to increase income exclusions in line with the Tax Court's majority opinion.

Planning Opportunities

• The Warren case is not an oddity. The fact that Dr. Warren had a very large income or substantial nonchurch income (approximately $200,000 from selling tapes and books) should not obscure the primary revelation of the case—the income exclusion was not limited to rental value. Ministers with more modest incomes may also experience tax savings.

• The most common application of Warren may be for tax years in which ministers make capital improvements to their homes. In the past, ministers who paid for a new kitchen, driveway, roof or other improvement had to worry that total housing expenditures for the year would exceed rental value. Many ministers handled this problem by allocating or depreciating the cost of the improvement over a number of years. But under Warren, the tax savings can be realized immediately, as long as the amount designated by the church is sufficient to cover total annual housing costs.

• It will now be critical to review annually the amount of MHA designated by the church. Because, under Warren, there is no cap on the income exclusion (except the amount spent), many ministers probably should arrange to have their MHAs increased. It is particularly important to plan ahead for major expenditures and have the MHA increased by enough to absorb all housing-related costs.

• Keeping good records of expenditures may now be even more crucial. Assuming Warren survives further challenges, audit situations may become simply a matter of requiring the minister to document the amount spent. In any event, there is effectively no limit (except total compensation) to the exclusion if expenditures are properly documented.

• How much should a minister worry about the Service auditing his return and reducing his housing exclusion? This is the first case that forced the Tax Court to grapple with the rental value ceiling. Normal IRS strategy is to carefully choose a case it thinks it can win, which would then serve as a precedent for harder or borderline cases. (The Service likely figured that the court surely would agree that Congress did not intend for a minister to get the kind of extravagant break enjoyed by Dr. Warren.)

It is difficult to speculate on the IRS's next move. It is tempting to guess that it will appeal Warren. After all, if it cannot prevail in an extreme case like Warren, the Service will be forced to completely surrender on this rental value ceiling. In any event, it is difficult to imagine the IRS insisting on a rental value ceiling for ministers in more normal situations when it lost 143 in this extreme case.

• Are there other factors that the Service could use to reduce the housing allowance exclusion? One judicial precedent is a little worrisome—the question of the source of the actual money spent on housing. In Marine, 47 TC 609 (1967), a minister sold his house and used the proceeds to buy another. The court required him to reduce his housing exclusion by the amount carried over from his old house. In effect, the court held that he had used only part of his MHA for housing.

The most obvious planning lesson is to caution a minister who is selling and buying to project how much he will spend on housing in excess of the equity received from the sale of his former home. If this excess amount is less than the amount he normally excludes from income, he should consider putting some of the sales proceeds in an investment account and financing a larger part of the purchase price.

If the IRS can trace home expenditures from the sale of the old home to the new home, it could apply the same principle when housing costs are paid from other sources. For example, suppose Dr. Warren had had a separate bank account for his tape/book income and expenses and that he made his mortgage payment out of that account. The Service could hold that he was not using his MHA to pay his housing costs. Or, perhaps a minister and a working spouse have separate checking accounts and the spouse pays some of the housing costs. The IRS has not attacked situations like these. However, it would be prudent to pay all housing costs out of the account into which the minister deposits his church compensation. This advice is particularly appropriate for those with relatively large MHAs who might be audit targets.

• Is there a connection between the MHA and Social Security? Although the MHA is excluded from income tax, it is income for purposes of the self-employment (SE) tax. Ministers who are self-employed for income tax purposes simply transfer their income after expenses from Schedule C to Schedule SE and add in the MHA. Most ministers, however, are employees for income tax purposes and do not file a Schedule C. These "dual tax status" ministers should ensure that their allowable ministerial expenses are directly deducted on Schedule SE, thereby shielding some of their MHA from SE taxes. This is a little tricky, because there is no specific line on Schedule SE to enter these expenses.

• How do MHAs affect retirement plan contributions? Self-employed ministers may contribute to Keogh plans and simplified employee pensions. Both self-employed ministers and employee ministers may participate in their church's or denomination's tax-sheltered annuity plan. Both categories of ministers may enter into salary reduction agreements and defer taxes on a portion of their earnings. Rev. Rul. 73-258 indicated that an MHA was compensation for purposes of computing retirement benefits. Many have assumed that an MHA could then be used in determining the amount of the maximum annual contribution. However, Robert Architect, a Senior Tax Law Specialist in the IRS Employee Plans Division, in an April 11, 2000 speech to the D.C. Bar Association, said that the Service has under consideration a ruling request to allow an MHA to count toward the Sec. 403(b) maximum annual exclusion. He indicated the IRS will likely rule against this minister (who is an employee). He did leave open whether the answer would be the same for a self-employed minister, as no such ruling request had yet been submitted. Ministers whose Sec. 403(b) deferrals are near the limit should closely monitor this situation.

From Robert D. Fesler, Ph.D., CPA, and Larry Maples, Ph.D., CPA, Tennessee Technological University, Cookeville, TN (Neither associated with DFK International)