Lior Pick, Attorney-at-Law, CPA
1. The Tax Options In Renting Out A Residential Apartment In Israel
Passive income from renting out a residential apartment in Israel by individuals is valued in three options: first – an exemption option according to the Income Tax (Exemption from Tax On Income From Renting Out Residential Property) Law, 5750-1990, up to a certain ceiling, second – a reduced tax option at a rate of 10% according to Section 122 of the Income Tax Ordinance, and the third option – that is fully taxable on the one hand, and on the other hand allows one to claim expenses.
This circular’s objective is to review the current options for taxing the income from renting out a residential apartment in Israel for the lessor.
For the purpose of demonstration, at the end of the circular, numerical examples are presented, to examine the profitability of choosing among the various options and their combinations.
2. Deduction at the Source Due to Payment of Rental Income
The Income Tax (Deduction from Payment of Rent) Regulations, 5758-1998, require the lessee to deduct tax at the source at a rate of 35% of the rent paid to the lessor if this expense may have been claimed in the deduction. At the same time, Section 32A of the Ordinance stipulates that if one was required to deduct tax at the source but did not, he/she will not be allowed to deduct the expense. In light of this, if the lessee is not the only one who uses the apartment for residence only, an exemption or a reduced certificate of deduction at the source must be obtained in advance from the tax authorities.
3. The Exemption Option
3.1. The Income Tax (Exemption from Tax on Income from Renting Out a Residential Apartment) Law 5750-1993 (hereinafter: “the Law”) exempts income from renting out residential apartments in Israel (by an individual lessor, including a representing taxpayer in a family company, renting to a lessee who is an individual or an association of individuals determined for this purpose by the Income Tax Commissioner) from tax, up to a maximal amount of NIS 4,790 per month (amount updated for 2011).
3.2. The Law defines a residential apartment as an apartment in Israel or in the area, intended for use as a residential according to its nature, not including an apartment that is registered or that should be registered in the registries that must be kept regarding the lessor’s income from a business. As a result, all of the lessor’s residential apartments that are not included in his/her business meet the definition.
3.3. The Law defines the term “rent” as the consideration from renting out one or more residential apartment that is used for residence by an individual lessee or by an association of individuals approved by the Commissioner.
3.4. Section 2 of the Law stipulates that the exemption shall apply to income from rent (as said above), provided only that the individual had no income from renting out residential apartments at an amount exceeding the ceiling (when the income exceeds the ceiling but is less twice the ceiling, a mechanism has been established in which each extra Shekel subtracts one Shekel from the exemption amount, up to the ceiling).
3.5. A rigorous review of the statute law shows that while the “exempt” consideration is only what is included under “rent” as defined by the Law, the calculation of the ceiling amount includes all income from renting out residential apartments, including for example apartments rented out to non-individuals or to associations of individuals approved by the Commissioner, as well as an apartment that is intended to be used according to its nature for residence but is not actually used as such, its income on the one hand will be calculated for the purpose of the ceiling amount for exemption, but of course they will not benefit from the exemption itself.
3.6. Let it be stated that from time to time, the tax authority argues that the deduction of the relative part of the depreciation expenses against the amount of taxable income (the amount exceeding the exemption ceiling) should not be allowed, but the matter has not yet been examined in adjudication.
3.7. Regarding the calculation of the betterment tax in selling an apartment that was rented out in the exemption option – according to Land Taxation Execution Order no. 5/2007, ongoing expenses should not be allowed, and the depreciation should be deducted from the value of the purchase (a deduction that corresponds with the addition of depreciation to the value of the sale in the 10% tax rate option). In the Lily Shimshon case (A.C. 1005/09) that was published in April 2010, it was decided that in calculating the betterment, a depreciation component not required in the deduction for tax purposes should not be subtracted from the cost, and thus it appears to greatly weaken the tax authority’s argument.
4. 10% Tax Rate Option
4.1. Section 122 of the Income Tax Ordinance (hereinafter – “the Ordinance”) allows an option that imposes only a 10% tax rate on the gross income from renting out a residential apartment, without stipulating ceiling income amount.
4.2. The only requirements in the Section are that the lessor is an individual (including a representing taxpayer in a family company) and that the apartment rented out is used for residence in Israel. The identity of the lessee, whether it is an individual, a company or otherwise, is inconsequential. It suffices that the apartment is used for residence in Israel.
Let it be stated that this option too shall not apply to the income of an individual that is considered income from a business as said in section 2(1) of the Ordinance.
One who has chosen to pay taxes according to this option shall not be eligible to deduct depreciation or other expenses and he/she will not be entitled to a setoff, credit or an exemption due to the income from the rent or from the tax that applies to it. For the purpose of calculating the betterment tax that applies when selling the apartment, the maximal amount of the depreciation or of the reduction that might have been deducted if not for the prohibition on deducing it in this option will be added. (This provision was stipulated in the Law, and thus it appears that the Lily Shimshon ruling mentioned above is not relevant in this case).
4.3. The tax payment in this option will be performed within 30 days of the end of the tax year (and not within 30 days of receiving the income, as it was before the amendment). Thus, one may choose this option retroactively for 2011 as well, provided that the tax on this income will be paid until 1.30.2012 (unless the individual paid ordinary advances in the 2011 tax year according to section 175 of the Ordinance).
5. Taxable Option
In this option, full tax is paid for the net income after deducting expenses and so on, as is custom for all other income from business.
6. Reviewing the Combination of Different Options
6.1. As we have seen, none of the reduced tax options (exemption or 10%) apply to income from a business and thus, in case the activity of the individual renting out mounts to a business, only the taxable option; that includes, of course, recognition of expenses, is open to him/her. However, if, for example, the lessor has a building that has many apartments for rent that constitutes a business, and in addition he/she has several more apartments elsewhere due to which the income is passive, he/she may pay regular tax on the business income, and the exemption option or the 10% option shall apply to the other apartments, as the case may be.
6.2. Combining the exemption option with the other options – the combination of the exemption option and the 10% tax rate option is almost never profitable, considering, as we have seen in the exemption option chapter (section 3 above), that statute law stipulates that when calculating the exemption ceiling all residential apartments will be taken into account, meaning, including apartments that are not included in the exemption option but in the 10% option (for example: an apartment rented out for residence to a company, or an apartment that is intended to be used for residence according to its nature, but was rented out for business activity)
Our opinion is that statute law enables a combination so that regarding a certain apartment, the Exemption Law shall apply, and regarding the other apartment, the 10% option will be required. However, the tax exemption ceiling shall be reduced by all sums that will be charged in the 10% tax rate option, and thus the aforementioned combination possibility is limited and is relevant in the following cases:
1) When renting out several residential apartments – only when the total income is higher than the exemption ceiling but lower than twice the ceiling.
2) When the income from renting out the residential apartments is lower than the exemption ceiling, but renting out some of the apartments does not meet the terms of the exemption as said in the Exemption Law, yet it meets the terms as said in section 122 of the Ordinance.
In our opinion, the exemption option may be combined with the taxable option when there are several apartments, insofar as entrance to the taxable option is not required by the law; meaning, this does not concern income from a business but passive income, and the taxpayer has chosen for his/her own reasons (for example high depreciation and financing) to enter the taxable option. However, the income in the taxable option will be subtracted from the exemption ceiling here too, and in some cases, we will lose more than we have gained.
Thus, when the total amount of income from the apartments does not exceed the exemption ceiling, it is not profitable to combine the exemption option with the other options, however when the total income exceeds the exemption ceiling but not twice the ceiling, the profitability of the combination should be looked into.
6.3. Combining the 10% option with the taxable option – one may combine the 10% option with the taxable option, as this option is not limited by a ceiling. One may for example pay a 10% tax rate on one apartment (say an old apartment that was bought many years ago, due to which there are no financing expenses and the depreciation due to which is low), and enter the taxable option for another apartment (an apartment purchased with high financing that is entitled to high depreciation).
7. The Profitability Of Choosing Between The Various Options
In Appendix A, numerical examples appear to demonstrate the profitability of choosing between the different options, and the conclusions arising from them are as follows:
7.1. When total income that exceeds the height of the exemption ceiling is involved, it is usually less profitable to choose the exemption option compared with the 10% option.
7.2. In case of recently purchased apartments due to which mortgages were taken, it is advisable to consider entering the taxable option due to them, and regarding old apartments without a high cost and without financing, it is profitable to enter the 10% option, so that the combination would result in a weighted tax that is less than 10%.
7.3. In case there is more than one apartment and the total income exceeds the exemption ceiling, but does not exceed twice the exemption ceiling, there are situations in which combining the exemption option and the other options gives the lowest tax outcome.
7.4. Needless to say, it is advisable to check the tax liability in each option based on income and costs (including depreciation) every year (but no later than 20 days after the end of the tax year, due to the payment duty imposed on people who chose the 10% tax rate option) and make a decision according to the results.
7.5. The taxpayer may choose the most beneficial option every year, subject to that said in section 7.4 above.
8. Income From Renting Out Abroad
8.1. A residential apartment in the Exemption Law is an apartment in Israel and in the area, and thus one may combine the exemption option according to the exemption for apartments in Israel and any option regarding an apartment abroad, that is a completely separate option that is not relevant to the rental income in Israel.
8.2. Needless to say, regarding the 10% option as well, one may combine it with income from abroad, as we have also seen regarding its combination with the taxable option in Israel.
Let it be stated that regarding the rental income from abroad, there is no difference between residential apartment and an office, etc.
8.3. For people who have rental income from abroad there are two options:
The taxable option, in which, other than the deduction of expenses, one may receive credit due to the taxes paid abroad or a option in which tax will be paid for gross income (after deducting depreciation) at a rate of 15%, with no option to allow other expenses and without credit due to the tax that applies abroad, in accordance with the provisions of Section 122a of the Ordinance.
8.4. One may make the calculations for each and every asset; and according to the tax outcome, the 15% option shall be applied to asset A and the taxable option shall be applied to asset B.
8.5. According to statute law, prima facie, one may infer that every year, one may choose a different option abroad regarding the same property, in light of the changing tax outcomes (increase/decrease in expenses), as statute law is silent about it, thus the taxpayer may choose the option most beneficial to him/her.
8.6. From the examples in appendix B one may see that the higher the depreciation amount and the lower the tax rate compared with the tax rate in Israel, the profitability of the 15% increases compared with the taxable option.
The aforementioned should not be perceived as a recommendation and/or expression of opinion. In all instances we recommend receiving professional individual advice in accordance with the concrete circumstances of each and every event. We would be happy to be at your disposal for any queries and or explanations regarding this or any general issue.
Lior Pick & Co. Legal Offices
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