Your Taxes: Is Real Estate Income Active or Passive?
Recent court cases shed light on whether income from Israeli real estate is taxable as active business income or passive investment income.
The distinction matters in terms of tax rates for rental income, loss utilization, and whether sale gains are to be treated as capital gains or ordinary trading income. Furthermore, if a business exists, it must immediately register and start reporting for Israeli tax purposes, and keep proper books.
Dima Trust Ltd Case
In the Dima Trust Ltd case, a family company rented a property made losses from renting out a property on a 400 meter plot of land in Neve Tzedek, Tel-Aviv (Dima Trust Ltd and Erez Yaacov Bar Haim vs. Tel Aviv 3 Assessing Officer, civil appeals 54447-06 -12 and 54488-06-12, Tel-Aviv District Court August 4, 2016).
A family company is transparent for Israeli tax purposes and its income is treated as the income of the largest shareholder. The largest shareholder tried to offset those losses as business losses against other income.
The Court sided with the Israeli Tax Authority (ITA) and said that renting out a single property did not amount to a business. It did not matter that the taxpayer intended to find other properties. Also, the fact that his wife was an architect was employed to assist in adapting the property to the requirements of tenants and the municipality, this did not deviate from normal upkeep by a property owner. As for maintenance expenses, these amounted to NIS 80,000 over four years, “at least according to evidence presented”, which was immaterial and necessary upkeep for a rental property that cost more than NIS 5 million and was merely spent on carpentry, gardening, drain repairs, toilet repairs and light bulbs.
There were no receipts for other claimed renovation expenses and no architectural designs.
Therefore, the Court ruled that the loss could not be used against other income as the rental activity was passive not business.
The Biran case
In the Biran case, in the Jerusalem District Court, a leading real estate lawyer and developer of very large neighborhood property projects owned and rented out 20-25 homes in the tax years concerned, in Jerusalem, Rehovot and Tel-Aviv. (Biran vs. Jerusalem 1 Assessing Officer, Cases 30384-01-15, 56689-04-13, August 7, 2016).
Rental income totaled NIS 830,000-NIS 921,000 per year. The taxpayer claimed the 10% tax rate available for passive residential gross rental income. The ITA claimed he was taxable at his marginal tax rate (up to 50%) on rental income net of expenses and depreciation, due to the number of homes and his knowledge of real estate.
The Court reviewed a number of criteria to determine whether the rental activity was active or passive, namely: taxpayer’s knowledge, the set-up, the bookkeeping, and the overall circumstances.
As for the taxpayer’s knowledge of real estate, the Court said it is like saying a reputable eye surgeon knows how to put eyedrops into itchy eyes.
As for the set-up, the taxpayer hired a property manager didn’t visit the properties or meet the tenants, didn’t sign rental agreements, and didn’t collect rent, and didn’t know the exact details.
The property manager also didn’t spend much time on the tenants and was no expert, but he used to rent an apartment as a student.
In fact the Property Manager was mainly involved in other activities and was paid close to the minimum wage for this activity. The apartments were received new and were quickly rented out using estate agents. The rentals were of a long term nature, some tenants remained long as 10 years or more.
How were rents collected? The property manager banked the rental checks from tenants in a specific bank account and marked them on excel tables that were handed to the accountants who prepared the annual report.
As for expenses, most repairs were covered by the builders’ warranty. The toilets and tiles weren’t upgraded. If the tenants changed, there was an agreement with the estate agents that they only collected commission from the tenant.
Therefore, the Court concluded there was no intervention by the taxpayer and no business set-up.
As for bookkeeping, if there is no business, the excel tables were enough and the bookkeeping rules for Israeli businesses don’t apply, according to the Court.
As for the number of properties, the Court cited an earlier judgment (the Dafna Leshem case) in which the taxpayers, two lawyers, inherited 27 rental properties – this was held to be a passive activity in the circumstances. Similarly, in this case, the taxpayer had many other sources of income, and the rental transactions were not large in comparison.
As for the overall circumstances, the Court pointed to the total lack of involvement of the taxpayer in the rental activities, they were not run like a business out to succeed.
The Court ruled that the rental activities were indeed passive and the taxpayer was entitled to the 10% tax rate.
These were District Court cases, so we probably haven’t heard the last word on whether real estate rental activities are active or passive. The cases above are relevant to Israeli and foreign investors, even Olim.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.