Five Tips to Fix Your Housing Allowance
By Raul Rivera
It is not news to anyone that a minister of the gospel can designate some or all of his/her salary from the church as a housing allowance and then exclude it from gross income so that, in essence, he/she receives it tax-free. Though this law has been in the books since 1921, many churches still largely misunderstand it. This is mostly due to the inherent imagery that the words "HOUSING ALLOWANCE" create in the minds of church leaders. What I mean is that when most ministers hear the words "housing allowance" they immediately think of a portion of money gifted to them to cover their housing needs. This misconception causes ministers to think they are not on salary if they are getting paid a housing allowance. Moreover, not only do they think they are not on salary; they are also unaware of the specific record keeping requirements.
While the housing allowance was designed to be a tremendous blessing to ministers, it can actually be an awful thing if it is not done right. The IRS' Minister Audit Technique Guide has it listed as one of the top income issues facing ministers today! Because of the persistent misunderstanding about the housing allowance, many ministers have been assessed major fraud fines and penalties for their failure to properly report it.
Such was the case with a minister whose tax return was audited. The IRS denied his housing allowance for the previous two years because it did not meet all the requirements set forth in the regulation. So instead of a tax savings, he was assessed penalties and interest that consumed most of his housing allowance. With that in mind, following are three tips that will help you perfect your housing allowance. We also discuss this topic in full and comprehensive details at all of our Ulitmate Church Structure Conferences.
1. Correctly document the housing allowance: The regulation requires that the church properly document the housing allowance according to the prescribed rules. Intention of the heart will not help you here. In order for the housing allowance to be valid, it must be documented in writing "pursuant to official action" of the church. That is done by the board of directors approving the housing allowance and documenting it in its minutes. There is very specific wording that should be used in documenting it to make sure it meets the requirements of the regulation (Section 1.107-1(b)). In particular, the wording must mention what I call the "least of three rule." See tip No. 2.
2. Know the "least of three rule": This special rule is what may make or break the validity of your housing allowance. The IRS regulation requires that a cap be clearly required and documented in housing allowance records. This means that the maximum a minister can claim on a housing allowance is limited to the lesser of:
- The fair market rental value of the home (including furnishing, utilities, garage, etc.). This requirement can be confusing. We take extra time to explain this one to make sure it is understood. Hint: it is not what you think.
- The amount officially designated (in advance of payment) as a rental or housing allowance, or;
- The actual amount used to provide a home, and cannot exceed what is reasonable pay for your services.
This tip also requires proper documentation. You must make sure that every year you have adequate records to show the values of each of the above items. Once that is substantiated with receipts and a housing allowance statement, one can rest assured it will pass IRS scrutiny. I will explain in the next tip.
3. Give it proper maintenance: Like the preventative maintenance one gives to a car, the housing allowance requires that you do the same. Every year the church and the minister need to give the housing allowance proper maintenance and document it in its corporate records kit. No document will do more than the housing allowance statement. It is a form that we have created that lists all of the minister's actual qualifying home expenses. It also contains a special formula that allows a minister to quickly calculate the "fair rental value" as required by the law. Finally, the statement designates the next year's upcoming housing allowance and properly allows the church to renew it year after year. This statement will be a lifesaver if you are ever audited.
4. Make copies: Always plan for the worst when it comes to taxes. As a minister, I always kept a personal copy of my housing allowance records. Though the church documented everything correctly, I always made the assumption that those records could be lost due to a fire, a flood, or just plain negligence. If I ever got audited, I did not want to depend on old records kept by someone else. This was even more important the three years following my resignation from the church we started in Florida. The IRS can audit your tax return for up to three years after they have been submitted.
5. Report it correctly: Did you know that though the housing allowance is free from Federal Income Tax it is still subject to self-employment tax? This is where many ministers miss it. Not only do many churches improperly document it, most ministers do not report it on Schedule SE of their tax return. The self-employment tax on the housing allowance as of 2011 is 15.3%. Therefore, if a minister's housing allowance one year is $25,000.00, then the tax due is $3,825.00. That brings us to another topic that I will cover in another article: applying for the exemption of self-employment tax.
How do I fix my messed up housing allowance?
Many pastors are not aware that the housing allowance cannot be set up retroactively. What I mean is that if you have not properly documented a housing allowance for this year, you currently do not have one and you cannot go create one and make it retroactive to January 1st of this year. But there is good news! You can set it up correctly beginning today. (Treas. Reg. 1.107-1(b)) states that you simply need to designated it in advance. This means that if your church officially designates it today, the rest of this year can be covered by a housing allowance.