By David K. MacLeod, CFP®, CFA

Pastors serve an important role in communities across the country. It’s not an easy job; they conduct worship services, preach on Sundays, provide one-on-one spiritual counsel, lead church staff, and perform weddings and funerals. Unfortunately, pastors also have complicated taxes partly because of the benefit of ministers housing allowance. It’s important for American pastors to understand ministers housing allowance and seek out trusted counsel to make sure they take advantage of this tax benefit.

 

Origin of MHA

Minister’s Housing Allowance (MHA, for short), has long legal precedent and was originally codified in the Revenue Act of 1921, not long after income taxes were upheld as constitutional in the 16th Amendment. Congress and the U.S. Tax Court re-codified and clarified MHA in the 1950s and 1960s.

MHA allows pastors to receive church-provided housing income tax free, which is a significant tax savings to pastors. Initially, the law applied only to a home on church property but later included a designation of a pastor’s salary to cover housing expenses.

 

Rick Warren v Commissioner of Internal Revenue (2000)

A legal challenge to MHA was brought when Pastor Rick Warren of Saddleback Church was audited by the IRS in 2000. He appealed a tax penalty related to MHA that ultimately went to the U.S. Supreme Court. That prompted Congress to act to clarify MHA with new rules that still stand today. The Clergy Housing Allowance Clarification Act of 2002 passed unanimously in both the House (408-0) and Senate and was signed quickly into law by President Bush only 6 weeks after the bill was first introduced. More recently, in 2019 a federal appeals court upheld the constitutionality of MHA.

 

Three-Part Test

The 2002 law introduced the three-part test which is critical for understanding MHA today.

For pastors who designate part of their salary for housing, MHA is limited to the LESSER of three amounts:

1)  The amount officially designated as MHA by the church board at the beginning of the year (in advance of any payment) as compensation for ministerial services.

2)  The total of actual housing expenses such as: rent, mortgage payment, property taxes, utilities, insurance, lawn care, etc.

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

The lesser of these three amounts calculated every year is the maximum allowed MHA for that year.

When pastors prepare tax return every year, any excess MHA amount determined by the three-part test should be added to income on the first line of Form 1040 with “Excess Allowance” written beside the amount, according to Richard Hammar, editor of Church Law & Tax.

For example, a church pays its pastor $70,000 per year. The church holds a board meeting in January to officially designate $35,000 for MHA. At the end of the year, the fair rental value of the pastor’s home for that year is determined to be $40,000 and the actual expenses for the year were $32,000. The actual expense amount of $32,000 is the lowest of the three amounts and that’s the MHA for the year that is income tax free. Since the church reported MHA of $35,000 through payroll, the pastor is responsible for reporting the $3,000 difference as excess allowance on their tax return for that year.

 

MHA in Retirement

A common misunderstanding among pastors is what happens to MHA when they retire from the church. It is possible for pastors to receive MHA in retirement on a pension or retirement plan, such as a 403(b)9 Plan account.

Policies vary across denominations and retirement plan administrators. It’s important to seek advice for your situation to find out if you qualify for retiree MHA.

For example, some denominations disqualify MHA treatment of retirement plan withdrawals if a pastor has completed a rollover of their retirement account. We should also note that a large denomination was advised recently by the IRS that retiree MHA is under study, and it may get challenged. Retiree MHA may not be around forever.

Common MHA Pitfalls

·     A church board cannot retroactively designate MHA. If the church doesn’t act at the beginning of each year and record the designation in its minutes, it deprives pastors of this significant tax benefit.

·     A rollover of a pastor’s church retirement plan account may risk losing the MHA benefit in retirement.

·     Pastors who own their home could lose a large tax benefit when they pay off their mortgage. A cost-benefit analysis is recommended for pastors who are inclined to pay off their mortgage early with a large one-time payment. However, the psychological benefits of being debt-free may outweigh the economic benefits to a pastor. Also note that there are housing expenses other than a mortgage that qualify for MHA.

·     Pastors must document the fair rental value of their home and keep good receipts of actual expenses, in case of an audit.

·     MHA provides an exemption from income tax, but NOT from self-employment (SECA) tax that a pastor pays. MHA is subject to SECA tax.

·     A pastor’s surviving spouse is not eligible for retiree MHA when a pastor passes away. This is important for tax planning and often overlooked.

Eclectic Associates is a fee-only fiduciary financial advisory firm in Fullerton, California. Feel free to call us to discuss your situation. We would be happy to talk to you to see if we can help.

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