United States: Clergy Housing - Parsonages and the Parsonage Allowance

Under long-standing tradition, many churches own private residences—known as "parsonages" —and make these residences available to church leaders without charge. The tradition dates back many centuries. But not all congregations own such structures. In lieu of rights to live in a church-owned parsonage, some congregations provide their ministers with cash payments known as "rental allowances" or "housing allowances" that their clergy use to meet rental or mortgage obligations.

Our federal tax rules support these alternative housing arrangements with an obscure income tax exemption known as the "parsonage exemption." This unique tax provision came into bright focus this past year in a controversial court proceeding followed by congressional intervention. But before describing these interesting events, some background on a parsonage’s tax treatment is useful.

The federal income tax law provides very few income tax exemptions. One such exemption is a "parsonage allowance" that a "minister of the gospel" uses to meet the minister’s housing needs. The parsonage tax exemption is long-standing. Having first appeared in 1921, the exemption is broadly construed as covering church-provided parsonages, "rental allowances" that a minister uses to rent a home and "housing allowances" that a minister uses to purchase a home. The exemption can even reach a pension distribution that a church designates as a parsonage allowance.

Given these flexible alternatives, the tax rules allow each church to decide whether and how best to provide clergy housing. The right alternative depends on many factors, such as church tradition, congregation size, composition, wealth, church location, and the recipient’s status within the ministry. A historic parish, for example, might be more likely to own a parsonage than would a newly formed church or a new religious movement. And such new churches might provide cash payments instead of rights to occupy the church-owned parsonage.

The parsonage allowance is not automatic. It is not self-executing. The exemption applies only if the employing church "designates" the minister’s payments as a parsonage allowance sometime before the tax year in which the minister uses the residence or receives the cash payment. The designation, however, is flexible. It may appear in the minister’s employment contract, the church minutes, the church budget, or any other document indicating official church action.

Assuming a parsonage allowance is properly documented, the minister simply excludes the rental value or the parsonage payments from his income tax return. And the church also omits the parsonage allowance from the minister’s wage amount reported on Form W-2.

Even though the parsonage is omitted from a minister’s tax return, the parsonage allowance has not escaped IRS scrutiny. Several years ago the Internal Revenue Service created a "specialization program" designed to educate IRS agents on auditing clergy tax returns. This audit program led to an income tax audit of Dr. Richard Warren, a founding pastor of the Saddleback Valley Community Church in California.

Dr. Warren’s audit involved the scope of the parsonage exemption and his housing allowance. Shortly after founding the church, Dr. Warren purchased a home. During the next three years, the church paid Dr. Warren a parsonage allowance that he used to pay his mortgage, utilities, furnishings, landscaping, repairs, maintenance, taxes, and insurance. The church designated the payments as a parsonage allowance and excluded these payments from Dr. Warren’s income.

At the conclusion of his audit, the IRS determined that a portion of these payments must be taxed. The IRS theorized that Dr. Warren’s parsonage exemption could not exceed the home’s fair-market rental value. In other words, Dr. Warren must be taxed to the extent the house allowance payments exceeded his home’s fair-market rental value.

Dr. Warren contested the audit results in the U.S. Tax Court. In May 2000, the Tax Court sided with Dr. Warren, holding that Congress did not create a fair-market value limitation for parsonage allowances. The Tax Court ruled that the exemption’s only condition or limitation was that the payment actually be used to provide a home. Since Dr. Warren used the payments to pay his mortgage and improve the residence, the Tax Court supported the exemption.

The government was not content with its Tax Court loss. It appealed to the Ninth Circuit and again asserted that the parsonage exemption could not exceed a residence’s fair rental value. In other words, the government framed the issue solely as a matter of statutory construction—whether a clergyman receiving a cash housing allowance can exclude the full amount of the allowance spent on housing or whether Congress capped the exemption at a home’s rental value.

In examining the government’s appeal, the Ninth Circuit took a sharp detour. It shunned the tax issue and invited the parties to frame the issue in constitutional terms. Both the IRS and Dr. Warren declined, but the Ninth Circuit persisted. It ordered the parties to address whether the parsonage exemption passes constitutional muster. The Ninth Circuit panel also appointed a law professor to brief the constitutional issues.

This judicial activism energized the religious community. Armed with the possible loss of the entire parsonage tax exemption on constitutional grounds, many religious leaders participated in an effort to craft a legislative solution. This call to arms encouraged Congress to pass the Clergy Housing Allowance Clarification Act of 2002.

President Bush signed this new act on May 20, 2002. With this new change, Congress caps the parsonage exemption at the amount of a home’s fair rental value. Thus, the maximum parsonage exemption is a home’s rental value, including furnishings and appurtenances such as a garage, plus the cost of utilities. The new cap applies to the 2002 tax year and years following.

After the President signed this new legislation, both the government and Dr. Warren moved to dismiss Dr. Warren’s tax case. In light of this joint motion, the Ninth Circuit had enough: it dismissed the case. Even with the detour, Dr. Warren’s parsonage exemption survived the IRS challenge.

Dr. Warren’s tax case served as a wake-up call for the entire religious community. Just the surfacing of Dr. Warren’s obscure tax issue indicates the IRS is paying more attention to clerical tax issues. This new challenge must be met. Clergy must be prepared to defend the amount of their parsonage. For parsonages paid as housing allowances, this defense will include evidence that the amount paid does not exceed a home’s fair rental value.

Rothgerber Johnson & Lyons LLP has many tax lawyers experienced in church tax issues and the parsonage exemption. Our lawyers can help churches properly document parsonage arrangements. Our tax lawyers are also well equipped to assist the clergy in meeting their tax challenges.