Your Taxes: When are landlords in business?

When does a landlord stop being a passive investor and become an active business in the real-estate field?

money (photo credit: REUTERS)
(photo credit: REUTERS)
Israelis love investing their spare shekels in bricks and mortar. But when does a landlord stop being a passive investor and become an active business in the real-estate field? Does it depend on the number of rental properties? This matters, because on residential rental income, individuals may be as low as 10% if the rental income is passive, compared with marginal rates up to 50% if the rental income is from an active business. On the other hand, only active business losses can be offset against other income that year, such as salary or capital gains, or carried forward and offset against any business income or gains in later years.
Recent developments: In the last three years, an Israeli district court twice ruled that owning 20 to 30 residential and commercial properties may still be passive.
In the Leshem Case, two lawyers, a brother and sister in a law firm, inherited 27 properties from their late father and let their secretary and bookkeeper continue handling the rental activity. In the Biran Case, a busy property lawyer owned 21 to 25 properties over the relevant years but delegated the rental activity to a team consisting of a property developer, a bookkeeper and a maintenance person.
On January 2, the Supreme Court overturned both of the district court’s decisions in one combined judgment and ruled that renting out 20 to 30 properties, residential or not, is an active business operation. Judge David Mintz wrote: “I am unable to accept the claim that 27 properties are a ‘modest’ amount of rentals… like a few properties.”
So where is the dividing line between passive and active rentals? On February 7, the ITA issued a draft circular discussing the Supreme Court judgment and clarifying its own somewhat conservative position in this regard.
Draft ITA circular position: The draft ITA circular says renting out up to five homes may be assumed to passive.
Renting out 10 or more homes should be classified as an active business operation. Renting out six to nine apartments will be tested by reference to general business criteria in the draft circular, which refers extensively to the Supreme Court judgment. The draft circular does not cover vacation homes nor other business properties.
Business criteria: The judgment reviews the business criteria and concludes that an operation with employees and a large quantity of activities constitutes a business.
The draft ITA circular quotes the judgment extensively and lists: type of asset, method of finance, period the property is held, familiarity with the sector, business setup, frequency of transactions and activities, financial size of transactions, degree of entrepreneurship (improvements and marketing) and the “overriding test” of the facts and circumstances. The ITA says not all these factors need be relevant in all cases; they are applied cumulatively with regard to the circumstances in a manner that allows a degree of discretion.
The ITA says when income is generated in a continuous systematic and frequent way, and this is linked to the personal effort of the manpower of the taxpayer or his delegate, this is a significant indicator of a rental business.
What the ITA knows about us: To show it means business, the ITA announcement of February 7 includes a table summarizing how many homes landlords hold in Israel, according to an ITA database as of last November.
Strangely, this table has since been removed from the ITA website.
In case you missed it, the table indicated that: 1,903,845 individuals hold one home, 219, 452 individuals hold two homes, 43,172 individuals hold three homes, 10,749 individuals hold four homes, 3,517 individuals hold five homes, 1,381 individuals hold six homes, 676 individuals hold seven homes, 358 individuals hold eight homes, 188 individuals hold nine homes, and 401 individuals hold 10 or more homes. That accounts for 2,183,739 homes in total.
Comments: Some doubt the accuracy of such data.
What about homes held via companies? And was the data presented as a warning to pay the correct tax on Israeli property, not just as a statistical oddity? Anyone renting rooms online should note the ITA has indicated this, too, constitutes a business if there are frequent rentals.
But the three-or-more homes tax law was struck down last year by the High Court of Justice as being enacted too hastily one night, and it has not been reenacted.
More issues arise at the macro level. What about Israeli investors in foreign property? And foreign investors in Israeli property? If they use property managers, are they in business if they hold six or more properties in all countries? Suppose they are elderly and/or disabled and clearly unable to run their own business? Finally, does the ITA have authority to rule that owning more than five to 10 homes means an active business exists?
As always, consult experienced tax advisers 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.