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Last week we reviewed investing in an Israeli home. In this article, we briefly review larger scale passive investment in Israeli real estate - for example, in an apartment building, shopping mall or commercial property. Much depends on how you structure the investment - as a company, individual or partnership. Also, special tax breaks apply in certain cases, as outlined below.
Note that development and construction activity is not covered here as it requires specialist advice on numerous aspects, including tax rates, taxation timing, VAT etc.
The regular Israeli tax situation:
In brief, in the case of passive real estate investments, Israeli taxes are generally imposed upon acquisition, occupancy, rental income and sale as follows:
* Acquisition - Acquisition tax at rates at rates of up to 5%, plus VAT of 15.5%.
* Occupancy - Municipal taxes on the floor-space ("Arnona").
* Rental income - Individual landlords pay income tax at graduated rates of 48% plus national insurance rates of up to 16.05% on the first NIS 35,760 of net rental income. However, 52% of the national insurance payments made are deductible for income tax purposes. Companies pay company tax at a rate of 29% in 2007, declining to 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter. Companies must also withhold tax from dividends paid to shareholders at a rate of 25% generally (resulting in combined Israeli taxes at a rate of 46.75% on distributed income in 2007). The dividend withholding tax rate decreases to 20% if the shareholder held under 10% of all means of control in the payor in the entire year preceding the dividend distribution.
Israel's tax treaties often reduce these withholding tax rates if upfront approval is obtained from the Israeli Tax Authority. Individual and corporate landlords must also collect VAT at a rate of 15.5% on the gross rent receipts. Depreciation is deductible on the building cost at straight line rates of 2%-4%, generally. If you don't know the split of cost between the land and the building, the building element is usually assumed to be two-thirds of the overall cost, as a rule of thumb. Finance costs may be 80%-100% deductible. Any resulting losses may be carried forward and set off against future income or capital gains from the same building.
* Sale - A 2.5% sale tax applies in certain cases - mainly real estate acquired before November 7, 2001. More generally, sellers are subject to land appreciation tax on capital gains from Israeli real estate interests at personal tax rates of up to 48%, on gains accruing before November 7, 2001. A rate of 20% (was 25% for sales before 2007) applies to gains accruing after that date. The split is calculated on a pro rata basis. If you sell shares in a "Real Estate Association" (a company whose assets are mainly Israeli real estate) you will pay land appreciation tax at these rates and the gain will be based on the fair market value of the shares sold. However, acquisition tax and sale tax are imposed on the value of the underlying assets of the Real Estate Association, ignoring any debt finance or other liabilities payable by the Real Estate Association.
* Foreign taxes: If you are a US citizen or non-Israeli resident investor in Israeli real estate, that is not the end of the story: You must also check the taxes in your home country and whether a credit is available for Israeli taxes on the same income or gains - this is common practice in many countries. If so, you might end up paying taxes in total at the higher of the two countries' tax rates, but hopefully not double tax. Because the real estate is in Israel, Israel will not give a credit for foreign taxes on such income and gains. Check also whether deemed dividends from an Israeli property company would be taxable when first derived under CFC (controlled foreign corporation) rules, if any, in the home country.
Israeli Tax Breaks:
Israel offers tax breaks for certain large scale property investments. These tax breaks can be nearly as substantial as those available for industrial and tech investments.
* Approved industrial, commercial and residential rental properties - Under the Law for the Encouragement of Capital Investments, "approved rental buildings" may qualify for reduced company tax rates on rental income and on sale gains if at least 70% of the floor space is rented out for residential purposes for at least five years, provided there are at least six homes in a new building or eight homes in an older one. The reduced company tax rates range from 10% to 18% after deducting straight lined depreciation of 10%-20% of the building cost. A tax holiday or grants may be available to other approved industrial properties, depending on their location. Dividends are subject to a 15% withholding tax. In the case of individuals, the income tax rate is generally limited to 25%. The approval has to be obtained upfront from the Israeli government. Proposals are reportedly being formulated to revise these tax benefits. Foreign investors from a few countries (e.g. South Africa, Singapore but not the US) may enjoy "Tax sparing" relief under their tax treaty with Israel. This means they credit the Israeli tax at regular rates against tax in their home country - to stop the Israeli tax break being lost back home.
* Real Estate Investment Trusts (REIT): The REIT was introduced in Israel at the beginning of 2006 with the aim of stimulating the Israeli real estate market. Similar vehicles exist in the US and the UK. A REIT is a publicly traded entity that enables the public to collectively participate in various types of investments linked to real estate without having to purchase a property directly.
The REIT must be a company incorporated in Israel and its business must be controlled and managed from Israel; its shares must be listed and marketed on the Tel Aviv Stock Exchange within 12 months after incorporation; at least NIS 200 million must be invested in real estate - at least 75% in Israel; at least 90% of income must be distributed by April 30 after year end; and shareholders are taxed on such distributions at source at full rates instead of the REIT company. Various other conditions also apply.
Income distributed to shareholders by a qualifying REIT will be taxed as income of the shareholders, not of the REIT and tax will be withheld at source, accordingly. However, short-term capital gains realized within four years will be taxed at ordinary income tax rates (up to 48% income tax as above) and "exceptional income" will be taxed at an astronomic rate of 70%. Exceptional income is income from sale of business inventory and any other income not from real estate, publicly traded securities, state bonds or deposits if it exceeds a minimum threshold of 5% of total income.
Note that Israeli provident funds and retirement funds resident in a country that has a tax treaty with Israel may be exempt from Israeli tax.
* Limited Partnership : The Israeli REIT tax regime is governed by rigid rules and limitations - this is the price of going public on a stock exchange. In the case of a private fund offered to less than 35 investors, a similar but more flexible result may be obtainable via the alternative vehicle of a limited partnership formed under Israeli or foreign law. The investors in a limited partnership typically enjoy limited liability but must leave the management to a general partner with unlimited liability. The investors will enjoy fiscal transparency (pass though) treatment and pay Israeli tax on their share partnership income based on their own tax status (up to 48% income tax - see above). Under current Israeli case law, sale of a partnership interest is treated like a sale of shares in a company.
* Foreign Investors' Entity: This vehicle may enable foreign investors to enjoy an exemption from acquisition tax and land appreciation tax on their shareholdings in certain cases. The main conditions are: Israeli or foreign company; at least 50 shareholders who were all individuals, foreign resident when they invested, and who hold under 5% each; and the company mainly builds, rents or sells buildings; and holds at least 50 homes. This status requires the upfront approval of the Director of the Tax Authority.
To sum up, larger scale property investments may be tax efficient and rewarding. The rules are complex and subject to change, so consult an experienced real estate lawyer and tax advisor in each relevant country.
The writer is an International Tax Partner at Ernst & Young Israel