To qualify for a parsonage allowance, the IRS first requires you to meet the definition of a minister. The IRS defines a minister as an individual who is “duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination.” Additionally, the minister must have the authority to perform key religious functions, such as leading worship, performing sacerdotal duties, and administering sacraments or ordinances according to the practices of their denomination.

What is the Parsonage Allowance?

For many clergy members, the parsonage allowance is an important part of their compensation package. This allowance allows qualified ministers to exclude from their gross income the fair rental value of a home or parsonage, including utilities, provided as part of their earnings.

However, it’s crucial to note that the housing allowance must be explicitly designated by the church or religious organization before the payment is made. If the church fails to designate an amount, the entire salary must be included in income, and the housing allowance will be disallowed.

Limiting Factors

The amount of housing allowance a minister can exclude from gross income is limited by the lowest of three factors:

  1. The designated housing allowance (as decided by the church or organization),
  2. The actual housing expenses incurred by the minister, or
  3. The fair rental value of the home, including furnishings and utilities.

In addition, if the amount of the housing allowance exceeds any of these limits, the excess must be included in the minister’s gross income.

Self-Employment Tax

It’s also important to understand that, although a minister’s housing allowance is generally excluded from gross income for federal income tax purposes, it remains subject to self-employment (SE) tax. Ministers are still required to include the parsonage allowance when calculating their SE tax.

For example, assume Minister Doe was designated a housing allowance from his church for $24,000 for the year. However, the fair rental value of the property, including utilities, was $20,000, and his actual housing expenses were $22,000. In this case, the amount Minister Doe can exclude from gross income is the lowest of these three amounts:

  1. The designated housing allowance: $24,000
  2. The actual housing expenses: $22,000
  3. The fair rental value, including utilities: $20,000

Since $20,000 is the lowest figure, Minister Doe can exclude $20,000 from his gross income. The remaining $4,000 (the difference between the designated allowance and the fair rental value) will be added to his taxable income. However, the full $24,000 (the designated housing allowance) will be subject to SE tax.

The parsonage allowance can be a valuable tax benefit for ministers, but it’s important to understand the restrictions. The amount you can exclude from income is limited to the lowest of the designated allowance, actual housing expenses, or fair rental value, including utilities. Any excess housing allowance above these amounts must be reported as taxable income. And remember, although it’s excluded from income tax, the allowance remains subject to SE tax.

If you have any questions regarding the parsonage allowance or a related matter, please reach out to your KT tax advisor.