By Adv. Etgar Kedem-Kaufman and Adv. Nicole Levin
The term “depreciation” describes the decrease in a property’s value over the term of its ownership. When dealing with Income Tax, the depreciation of assets and equipment is considered part of the business activity and therefor deductible from the profit, resulting in the reduction of the profits, subsequently reducing income tax. In the sale of real estate, depreciation works in the reverse. It is subtracted from the purchase price, causing the purchase price to be reduced, which results in an increasing in the land appreciation from the sale and thus the Land Appreciation Tax (LAT) is increased.
A person who owns a residential apartment that was rented for residential purposes, may be liable to deduct depreciation upon selling the apartment, based on the income tax route chosen by him while renting out the apartment. When dealing with income from residential rentals, there are 3 tax routes: marginal tax, reduced tax (10%) and full or partial exemption. Below is a brief explanation of each tax route and its effect on the LAT calculated in the sale.
A taxpayer may choose any of these routes:
- Tax exemption (full or partial):
Full exemption: If the monthly income from rent does not exceed 5,470 NIS per month as of 2023, a full exemption will apply to the income.
Partial exemption: When the amount of monthly income from rent is higher than 5,470 NIS but does not exceed double the sum (NIS 10,940), the exemption shall be calculated according to an equation set out in the law. The tax will be subject to the owner’s marginal tax rate, considering his other income.
When the amount of monthly rental income exceeds the exemption amount of NIS 10,940, no exemption will apply, and the entire rental income will be taxed. In this case, an individual can choose between a reduced tax route of 10% or a marginal tax route.
When the apartment is sold, depreciation accrued must be deducted retroactively going back to February 2007, even if the apartment was rented before that date.
- A reduced tax charge of 10%:
A reduced tax of 10% of the rental income can be paid under the following conditions:
- The apartment is used for living.
- The rental income is not income from a business.
In this route, at the sale, depreciation accrued must be deducted, retroactively, from the commencement of the rent, even if rented before 2007.
- Taxation according to marginal tax:
Under this route, the rental income shall be taxed according to the landlord’s marginal tax rate. If the owner is 60 or older, his rental income will be taxed beginning from the first income tax bracket (10%). If the landlord is under 60, then his rental income will be taxed according to the first tax bracket levied on income from passive sources, which commences at 31%.
In this case, if the owner has demanded depreciation from the Income Tax Authorities during the rental period, then upon sale, depreciation accrued must be deducted. If the owner did not demand depreciation during the rental period, in good faith, then deduction of depreciation at sale shall not be required.
How does the tax route chosen influence the LAT levied upon sale?
Under LAT depreciation is calculated as follows: an annual rate of 2% of the purchase price multiplied by the duration of the lease. The depreciation is to be subtracted from the purchase value resulting in the increasing of the land appreciation accrued from the sale and thus enhancing the LAT.
The ramifications of depreciation can be seen in the following examples:
Purchase price: 1,000,000 NIS.
Sales price: 3,000,000 NIS.
For simplicity, inflation shall be ignored:
- Apartment rented out under the marginal tax route and the owner has not claimed depreciation during the rental period from the Tax Authorities or the Apartment was not rented out at all:
3,000,000 NIS – 1,000,000 NIS = 2,000,000 NIS (capital gains)
2,000,000 NIS *25% (LAT rate): 500,000 NIS LAT
- Apartment was rented out for 20 years, under the marginal tax route and the owner has claimed depreciation from the Tax Authorities or under the full or partial exemption route or under the reduced tax route of 10% :
1,000,000 NIS*2% = 20,000 NIS
20,000 NIS*20 years = 400,000 NIS.
1,000,000 NIS – 400,000 NIS = 600,000 NIS
3,000,000 NIS – 600,000 NIS = 2,400, 000 NIS (capital gains)
2,400, 000 NIS*25% (LAT rate): 600,000 NIS LAT.
- Apartment was rented under the full or partial exemption route and the rent commenced before 27th of February 2007, for example, the rent began on the 1st of January 2000, for a period of 20 years. The LAT shall be approximately, 565,000 NIS.
We see from the above example that the Income Tax route chosen directly affects LAT. Therefore when renting out an apartment, one should consider the best tax route, bearing in mind the ramifications on LAT at sale in the future.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writers are Israeli real estate attorneys.
Nicole Levin is also an expert on the Preservation of Israeli historic buildings