The Israel Tax Authority in February published a circular draft clarifying the classification of income from residential units.
The circular explains the considerations according to which the income from residential units should be considered income from business, rather than passive income (private income entitling the landlord to potentially lower tax rates). Based on the current draft:
- Leasing 10 or more residential units constitutes a fully taxable business according to the Tax Authority, with tax rates up to 45-50 percent
- Individuals leasing 5-9 residential units will have to convince the Israel Tax Authority that they should be granted the passive income rates, after review on an individual basis
- Income from leasing up to five residential units will be judged as passive income and be eligible for a reduced 10 percent tax rate, provided that the other criteria are met
The publication comes after the Supreme Court upheld appeals by the state to two parties each owning 24 residential units. The ruling states the owners must pay the same tax on the leasing of the residential units as someone operating a business, rather than the tax applying to owners of private housing units entitled to a lower rate.
It should be noted that even if the income is deemed to be business activity, there is an exemption from VAT for rents of residential properties.
Criteria for Judging Passive vs. Business Income
The circular gives broad guidelines for how the Tax Authority will review individual cases for ownership of 5-9 residential units, including:
- The number of residential units owned, the amount of income derived from their rental income, and what percentage of an individual’s overall income is derived from rental income
- The frequency and nature of transactions to support rental income from the residential units, including rental agreements, marketing, bookkeeping, collecting rent and maintenance of the property
- The knowledge and experience level of the property owner about how to generate income from renting residential units, which includes teams hired by the owner for their expertise
- The consistency of income generation from residential units, including office space, staff and budget dedicated to maintaining rental income
- The reinvestment of funds for development and improvement of the residential units to increase profits derived from rental income
Additional criteria were given less weight by the Court and Tax Authority:
- The financing behind the residential units, with loans and their associated risk seen as an indication of running a business operation
- The quality of the residential unit, as either a long-term investment or short-term purchase, with long-term purchases more likely associated with passive income
- The duration of ownership, with shorter term ownership seen as indicative of a business goal
- An overall judgment evaluating unique circumstances behind the ownership and rental income from residential units
Questions that Arise
There are other some interesting questions that arise from this, including:
- Can a taxpayer change a previous return if this will result in a lower tax bill?
- Will the Tax Authority stick to their business route of taxation in situations where there are significant tax savings to be made? Most noticeably, this is likely to affect mothers whose only income is property, as well as those defined as disabled by the Tax Authority.
- Does this apply to foreign properties? And what about a situation where a taxpayer owns, for example, three properties each in four countries?
As ever, a tax circular has attempted to clarify matters, and has only succeeded in muddying the waters further!