YOUR TAXES: Fiddler on and off the roof

A taxpayer who did not lawfully report income cannot avoid depreciation recapture.

money (photo credit: REUTERS)
money
(photo credit: REUTERS)
The Supreme Court has just handed a small victory to the Israeli Tax Authority and a bigger one to property-owning taxpayers. It dealt with depreciation recapture, which may sound technical, but it matters to many people and companies.
Depreciation recapture means adding previously deductible depreciation to a capital gain for capital gains tax purposes when a property is sold, because it is assumed the seller already deducted that amount from rental income. The idea is to stop the seller getting a double deduction.
For example, imagine you bought an Israeli property in 2010 for NIS 1 million and 10 years later you sell it for NIS 2m. And in the 10-year ownership period you rented out the property and claimed depreciation totaling NIS 267,000 (2.67% per year per Israeli tax regulations).
When you sell the property, you pay Israeli land appreciation tax (mas shevach) at a rate of 28% on NIS 1,267,000 (= the gain of NIS 1m. plus depreciation of NIS 267,000). You write a tax check to the Israeli Tax Authority for NIS 354,760 in this example. (The gain would also be adjusted for inflation in Israel, currently minimal)
But what if you didn’t deduct the depreciation during the ownership period for some reason?
What the tax laws say
The Israeli tax laws dealing with both real estate and other assets, such as vehicles, say you must add back “deductible depreciation” to capital gains. Past court cases supported this, but the Supreme Court has now changed its mind – in Hadera Real Estate Tax Director vs PIV BV (5883/18 of December 2, 2019).
Facts of the case
A Dutch company owned a home in Caesarea but fiddled its taxes. The company apparently did not file tax returns reporting rental income it received and so no depreciation was claimed. When selling the property, the taxpayer claimed no depreciation recapture should apply and the land tax tribunal agreed. Not surprisingly, the ITA was concerned that floods of landlords would be motivated to fiddle their taxes and appealed all the way to the Supreme Court.
The Supreme Court first reviewed the legislative intent. The Knesset wanted to avoid the need for ITA officials to go back years, sometimes decades, to check how much depreciation had been deducted.  The twin aims of the law are to levy the right tax on the actual gain, and to prevent taxpayers getting an unfair double deduction.
The court realized that there may be genuine cases when depreciation was not claimed. So the Supreme Court laid down new rules for depreciation recapture, as follows:
In general, it is assumed the taxpayer deducted full depreciation that was deductible against income, which is then added to the sale gain.
If the taxpayer lawfully reported  income and paid tax but proves he refrained from deducting depreciation, such amounts of depreciation will not be added back to the sale gain;
A taxpayer who did not lawfully report income cannot avoid depreciation recapture.
Case result
In this case, the taxpayer fiddled his income taxes and the court ruled depreciation recapture was appropriate when the property was sold. In other cases, taxpayers may now apply the above rules. So the ITA won the battle and lost the war. If taxpayers can prove they lawfully didn’t claim depreciation, they may avoid depreciation recapture.
Comments
This case is very good news for olim among others. For example, an oleh may have lawfully not deducted depreciation in the following cases regarding real estate outside Israel:
During their 10-aliyah year tax holiday for foreign income and gains; if the property didn’t initially belong to them, it belonged to a relative who gave or bequeathed it to the oleh; If the property was acquired pre-2003, foreign income was generally outside the Israeli tax net up to the end of 2002 provided the income was not first received in Israel (unlikely).
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd. [email protected]