Your taxes: Renting out 28 properties – active or passive?

By LEON HARRIS
money (photo credit: REUTERS)
money
(photo credit: REUTERS)
How many homes can an investor own and still qualify for lower tax rates for passive income in Israel? Until recently, it was generally assumed that rental income from a handful of homes – say five or six – may be considered passive, but any more may result in the entire rental income being taxed as an active business or trading activity. But now a Tel Aviv District Court judgment has just raised the bar to 28 homes! (Leshem vs Tel Aviv 4 Assessing Officer) Background: Many people put some of their money into bricks and mortar (or concrete) as an investment and/ or to help provide housing for their children when they grow up.
In the case of individuals, passive rental income from Israeli real property above an exempt threshold of NIS 5,070 per month (in 2015) can be taxed at the taxpayer’s option: (a) at 10 percent of gross rental income, or (b) at the taxpayer’s marginal tax rate (up to 50%) on net rental income.
And passive sale gains of individuals may be taxed at 25%. However, business income and gains of individuals are all taxed at the marginal tax rate of up to 50%.
In the case of companies, a uniform company tax rate of 26.5% applies to active and passive income.
So passive income of individuals may be taxed at lower rates. The trade-off is that passive loss utilization is more limited than active business losses.
Foreign investors should also check their tax position in their home country and their ability to credit Israeli taxes there.
The facts of this case: In the Leshem case, the taxpayers were two adult children who inherited from their father 28 rental properties, of which four were commercial properties and 24 were residential properties. Fourteen of the residential properties were indeed used for residential purposes, and 10 were used as offices. The father in his lifetime and the two children were practicing lawyers.
A law-office secretary dealt with administrative aspects, and a cleaner was employed to clean the stairwells in one of the buildings.
The Israel Tax Authority (ITA) treated the rental income in the father’s hands as passive income and denied loss relief. But when the children inherited the properties and claimed the 10% tax rate, the ITA denied that too and claimed the rental income was now active business income.
What is business income? The court reviewed in detail the criteria for distinguishing between active business income and passive income. It cited among others the renowned Judge Dr. Bein in the case of Mordechai vs Haifa Assessing Officer: “To sum up... you have to distinguish activity associated with the ownership of property without which you cannot describe the rental at all, such as fulfilling legal obligations by the landlord for the tenant such as repairs to and around the leasehold property and collecting the rent, FROM activity that goes beyond these routine activities, such as marketing and publicity campaigns, activity to make the leasehold property more attractive (not just ongoing maintenance), finding investors to develop the property and to increase their value.”
In this case, the court concluded that the taxpayers’ activities did not deviate from the regular and reasonable activity of landlords and that any personal toil was minor in relation to the main source of income: the properties themselves, despite the number of properties and the amounts involved.
The properties “fell into the hands of” the taxpayers as an inheritance. And a review of the circumstances support the conclusion that income derived was passive in nature.
However, the court ruled that the 10% tax rate was only available for properties actually used for residential purposes, not as offices. Consequently, around half the properties qualified for the 10% tax rate, and only 50% of expenses incurred could be claimed against regular taxation of income from properties that did not qualify for the 10% tax rate.
What about the ITA’s attitude? The ITA claimed it is entitled to treat each year separately, so it could switch from assessing the rental income as active instead of passive income. The court declared it is still significant how the ITA viewed things in the past.
The court criticized the ITA but of course couched it in relatively polite language. “It is not comfortable to think that the appellant (the ITA) changes its position on the question of how to classify the rental income when the circumstances are all too similar... a duty of decency obliges the administrative authorities, including the appellant (the ITA) carrying out such judgmental assessment procedures, to be consistent in its positions and to speak with one tongue in relation to the same circumstances.”
Concluding remarks: We glean from this case that renting out 28 properties may now be passive and not active in nature. It remains to be seen if an appeal will be lodged with the Supreme Court.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
leon@hcat.co Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.