The Israel-US tax treaty determines the tax fee and the order in which it is performed. Certain income of taxable in the US, and Israel has the right to charge the residual tax (the difference) whereas other income is taxable only in Israel, under certain conditions.
Beyond the tax treaty, there are also Israel’s internal tax laws that determine the track and tax rate and provide comprehensive information on the ability to offset losses.
Income from real estate, whether from selling the property or regular income from rental is taxable first in the US, and Israel is eligible to the differences alone.
Rent income
The investor can choose one of two tracks each year.
Fixed tax track (section 122A) – taxation of 15% of the income, with no deduction of expenditure (excluding depreciation) or offsetting foreign taxes. This track is suitable for those at a high tax bracket (with a significant income) and those who did not accumulate many expenses throughout the year.
Marginal tax track – income is added to the rest of the taxpayer’s income. Under the age of 60, the bracket begins at a rate of 31%, and at 10% for those over the age of 60. Taxpayers who choose this track can deduct all expenses used to generate income, and foreign taxes can be reimbursed. Suitable for those with lower income and over the age of 60, who have accumulated many expenses throughout the year. Once profits in this track exceed 30,000 ILS, payment may be due to the national insurance (Bituach Leumi).
Of course, the ITA can also define an investor as having an income from a business or trade according to different tests of number of assets, income, etc.
Offset of losses:
Section 29 determines that losses from rentals outside Israel can be offset by other rental profits from outside Israel, or by capital gains accrued from the same property that generated the loss. If no other losses took place during the tax year, the loss is accumulated for the following years, and can be offset by the same profits.
Income from real estate sales
Income from real estate outside Israel is not included in the real estate taxation law, but rather in Part 5 of the income tax ordinance as capital gains. Section 121 orders a tax of 25% on capital gains accumulated by an individual. The income tax authorities do not tax rate differences, and so profits created due to the change in exchange rates are exempt from taxation. If the property was used as a rental property, the capital gains will include the accumulated depreciation. It is important to note that depreciation in Israel can be different both in value and relative portion, and in depreciation rates.
The ITA requires that a sold property will be reported within 30 days, and an advanced will be paid for it.
Offset of losses
Section 92 determines that capital loss outside of Israel will first be offset by capital income from outside Israel; if no such income exists, capital loss can be offset by capital income from Israel. Should that not exist either, capital loss may be offset by income from interest and dividends. Should none of these exist, and a tax report was filed, the loss may be transferred to subsequent years and be offset according to the same arrangement in the future.
Capital income does not include business inventory. The sale of real estate can be considered inventory if the span of transactions is significant.
Re-exchange
Section 96(c) determines that if the country of origin allows for property re-exchange – like section 1031 in the US – Israel will view such transaction as owing full tax, but shall maintain said tax as credit until the time of selling the newly acquired property.
LLC in Israel
The ITA published two circulars concerning LLCs. The first, 3/2002, determines that the LLC will be considered “a group of persons” for tax purposes – simply put, a company owing double taxation. The second, 5/2004, determines the rules of foreign taxation – US tax vs. Israeli tax. This circular distinguishes between two cases:
- Managed and controlled in Israel
- Managed and controlled outside Israel
In case 1, the ITA requires that the LLC report its income and be taxed according to the company tax (currently 23%). The ITA will unbind the individual’s tax credit in the US from the company tax. In the case of profit withdrawal, the ITA will consider it as a dividend to the shareholder, taxed according to section 125b.
Example:
$10,000 income owing 10% in taxes to the federal government, and an additional 2% to the state.
Income – $10,000
Company tax rate – 23%
US tax rate – 12%
Dividend tax rate – 30%
Total tax – $4,610 or 46%
In case 2, management and control takes place outside Israel. “Management and control” is an inseparable term, and so it is sufficient if only one of these definitions is lacking. In such cases, the ITA enables shareholders to disclose income – i.e., the ITA view this income as though it belongs to an individual, and categorize it accordingly. If the LLC comes from rental, the ITA considers the taxpayer to have earned rent, and tax accordingly. In other words, full correlation between taxation in the US and Israel. In this instance, division of profit is exempt and does not require additional taxing.
Same example according to case 2:
Income – $10,000
Individual tax rate – 31%
Total tax – $3,100 or 31%
An investor who founded an LLC that generates rental income may not take the fixed tax track according to section 122a, which is reserved to individuals, whereas an LLC is “a group of persons.”
The circulars only refer to transparency for foreign taxation purposes and do not consider the possibility of offsetting losses or choosing between tax tracks. Nevertheless, the very fact that the ITA defines an LLC as “a group of persons” reveals that interpretation of losses or a choice between the tracks is impossible.
Disclosure is done by filing form 150 of the ITA, in addition to the Israeli income tax report (see attached).
In order to bypass the shortcomings of the LLC in terms of loss offset and choosing the fixed tax track for a rental property, it can be registered as a family or “house” company in Israel. Registration should be done up to 3 months from the day of the LLC’s formation. The only downside is section 373a of the ITA law, which is currently under court discussion.
