Your Taxes: Tax issues of all-rental residential property

The Knesset has just passed the Law for the Encouragement of Construction of Residential Property, 2007.

By LEON HARRIS
taxes 2 88 (photo credit: )
taxes 2 88
(photo credit: )
The Knesset has just passed the Law for the Encouragement of Construction of Residential Property, 2007. This will be of interest to readers of our recent article, "The implications of investing in local property" (The Jerusalem Post, March 28, 2007). The law allows an Israeli company that owns a residential "rental building" to elect special tax treatment as outlined below. The election is not for everyone, but if you make the election, you cannot cancel it. A "rental building" for these purposes is a permanent building designated for planning purposes as residential with at least 16 apartments on at least floor stories, with an average main floorspace of no more than 100 square meters (unless otherwise allowed under regulations). The construction must be completed on or after January 1, 2007, based on connection to the electricity, water or telephone networks. At least 70% of the apartments must be rented out for residential purposes and the remaining apartments must not be put to other use. The lease must specify periodic rental payments for a year or less and not involve letting to a related party (as defined, includes 25% common ownership), nor to certain government ministries - namely the Absorption or Construction and Housing. The landlord company is responsible for management and maintenance of the building in the state it was when construction was completed. There are two main tax benefits on offer - accelerated depreciation and exemption upon sale - if various conditions are met. The accelerated depreciation rate is 20% per year on a straight-line basis if the building is operated by the same company as "rental building" for at least 10 consecutive years. If this begins during a year, a pro rata portion of the depreciation is allowed. A lower depreciation may be selected in the first year - if so, it cannot be changed in subsequent years. Any resulting loss can be set off against other income of the company in the same year or against future years' income from the same building. If a building stops meeting the "rental building" conditions, the extra depreciation claimed in prior years is added back to taxable income in the first year of non-compliance with 4% inflation adjusted "interest." If a company sells all its rights in an entire "rental building" that it owned for at least 10 consecutive years, it will be exempt from land appreciation tax on the portion of gain that accrued from the beginning of 2007, provided the building is not sold to a related party. However, the purchaser must be another Israeli company that undertakes to continue operating the building as a "rental building" for the balance of 25 years. Otherwise, the purchaser must pay the tax, including the seller's tax plus indexation and 4% interest. In other words, to enjoy a sale exemption, a "rental building" must remain that way for at least 25 years in total. The law includes a number of safeguards to make sure all the "rental building" conditions are met, including the following: * The Tax Director may require an accountant's confirmation of compliance. * The land registry must include a caution that the building is a "rental building" unless otherwise approved by the Ministry of Construction and Housing. Registration of a sale requires similar approval. * Rent control regulations may be issued by the Minister of Construction and Housing. Is it all worthwhile? The new law has attracted criticism. The law applies to smaller apartments and rigid conditions apply for up to 25 years. The accelerated depreciation is just that - depreciation would be granted in a later year under normal rules. And the landlord company's exemption from land appreciation tax is somewhat illusory - any dividend or liquidation of the company by shareholders to extract the gain will be taxed in Israel at rates of 20% to 25%. Foreign shareholders of a few countries may enjoy lower tax rates under a tax treaty, but they may also be taxable in their home country. Furthermore, it is unclear whether 15.5% VAT applies to sale consideration and whether input VAT on construction and other costs is recoverable. As always, consult legal and tax advisers in specific cases. Have your say: Any real estate investors reading this piece are invited to send me their comments on this new measure. As we celebrate Israel's 59th Independence Day this week, I will donate NIS 59 to charity for each of the first 10 e-mails I receive. Happy Independence Day to all our readers. leon.harris@il.ey.com The writer is an International Tax Partner at Ernst & Young Israel.