Until recently, taxpayers were generally accustomed to choosing between two principal tax regimes for rental income derived from residential properties in Israel (there is an additional regime, but it is beyond the scope of this article).
However, the courts and the Israel Tax Authority have determined that where a taxpayer rents out a significant number of residential properties, the rental income may be taxed at the taxpayer’s marginal income tax rate, which may reach 47%.
The current tax regime for residential rental income ranges from a tax exemption (up to rental income of ILS 5,030 per month) to a 10% flat tax on gross rental income.
Recently, the Supreme Court of Israel, in two separate judgments, held that rental income earned by individuals who own more than 20 residential apartments constitutes business income, taxable at the taxpayer’s marginal tax rate, rather than passive income eligible for the reduced tax regime.
In its draft Income Tax Circular on the classification of income from residential rentals, the Israel Tax Authority established the following rules of thumb:
Rental income derived from up to five residential apartments (inclusive) will generally be regarded as passive income, which may qualify for the reduced tax regime.
Where the taxpayer rents out ten or more residential apartments, the income will generally be classified as business income, subject to taxation at the taxpayer’s marginal tax rate.
Where the taxpayer rents out more than five but fewer than ten apartments, the classification will be determined based on several factors:
A. Frequency of transactions and the taxpayer’s level of involvement in managing the properties.
The greater the number of lease agreements entered into by the taxpayer, and the greater the taxpayer’s involvement in the management and maintenance of the properties, the more likely the rental income will be regarded as business income.
B. The taxpayer’s expertise and professional knowledge.
If the landlord is, for example, a real estate broker, appraiser, attorney, or contractor who regularly engages in residential real estate transactions and improves properties acquired over the years, the rental income is more likely to be classified as business income.
C. The existence of an organized and ongoing business operation.
The regular involvement of professionals supporting the rental activity, such as marketing personnel, accountants, or maintenance staff, may indicate that the rental activity constitutes a business, resulting in the income being classified as business income.
D. The holding period and the circumstances of the transactions.
This factor assists in determining the overall nature of the taxpayer’s activities in relation to the properties and, accordingly, the proper classification of the rental income.
In conclusion, individuals who regularly engage in the purchase, sale, improvement, and leasing of residential properties are now more exposed than ever to having their rental income classified as business income and taxed at the applicable marginal income tax rate.
