This is an informal statement of what other pastors have found and should not be taken as legal advice of any form, and might possibly be wrong.
Pastors are traditionally very badly paid. One of the primary ways that many pastors can afford to survive is that the United States government gives pastors a tax break through a housing allowance. The actual law in section 107 of the IRC reads “In the case of a minister of the gospel, gross income does not include—(1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as a part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.”
Basically, this means that if the congregation a pastor is serving at wishes, they can designate some of the pastor's income as housing allowance. Therefore it cannot be taxed, except for Social Security due to self-employment taxes. Any pastor that is currently serving a church, whether they are a senior pastor or associate, can have a housing allowance. However, the pastor cannot simply assume that some of his income is housing allowance, nor can it be designated retroactively. Housing allowance only takes affect after being designated by the board. This must be an official statement by the board, one that appears in the official minutes. It is a good idea to be explicit that this is a designation for that year and all future years unless otherwise noted, or that a certain percentage of all pastor's salaries will be housing allowance unless noted. This will protect the pastor if a specific designation is not set upon a new hire or a new year. But other than the designation, there is nothing different about the money.
This housing allowance can include the estimated cost of rent, utilities, furniture, improvements to the house, and even cleaning supplies. Anything that deals with where the pastor lives can be counted. However, if the mortgage of the pastor's house has been paid off, the pastor can no longer count what the mortgage once was in his/her housing allowance. Instead, only the maintenance of the property can be counted.
If, on the other hand, the pastor is living in a parsonage, or is having his/her housing paid for by the church, the rental value of the parsonage should be counted as income, but not taxable except by Social Security. Again the board sets the fair rental price of the parsonage but it must be within the reasonable limits of the surrounding area.
However, even if the church board authorizes a specific amount that does not mean it can all legally be claimed. Only the amount used can be claimed for housing allowance, and a pastor can only claim up to the amount designated for housing allowance by the board. Any money designated for housing allowance, but unused, becomes taxable. Up to 100% of a pastor's income can be accounted for, but this number cannot exceed a “fair market value” which is of course debatable. Basically, don't have $100,000 a year in housing allowance if the average rental price of a home in your area is only $15,000. If the pastor miscalculates, or claims more than they use or what is reasonable it is on their head, not the church board's.