In direct response to the appeal decision in the Biran case the Israeli Tax Authority issued February 8, 2018 a draft circular setting out when rental income of multiple residential properties will be considered in the future by the Israeli Tax Authority as business income versus passive rental income.
The dispute of the classification of rental income is relevant for the question whether para. 122 of the Israeli Income Tax Ordinance with its favourable tax rate of 10 % is applicable or the rental income is taxed with the progressive tax rate for individuals according to para. 121 of the Israeli Income Tax Ordinance.
In the Biran case the taxpayer owned more than 20 apartments. He argued that the rental income is passive income and accordingly applied the tax rate of 10 % on the brutto rental income. The tax authority, in contrast, argued that the rental income of multiple apartments is to be considered business income and taxed the income according to the progressive tax rate. The Court of Appeals accepted the position of the Israeli Tax Authorities. The Court of Appeals explains that the rental activity of multiple residential properties can become a real, systematic and frequent occupation of the taxpayer that requires significant human and personal input. As far as the rental activity requires this kind of systematic employment it is an indication that the rental activity becomes a business. The Court continued that it is very difficult to set a rigid quantitative threshold. However, the rental activity of more than 20 apartments rises to the level that requires the operation of a real business. In the decision the Court of Appeals outlined considerations to be taken into account when examining the classification of the rental income of residential property as business income or passive income.
In the recent draft circular the Israeli Tax Authority picks up on these considerations and summarizes them in order to classify rental income of residential property as business income or passive income. It should be noted that the circular only applies to residential property and does not relate to holiday apartments or to the rental of other business assets.
In short, the Tax Authority determines that the rental of more than 10 residential units are classified as business income. In case the taxpayer claims differently, he has the burden of proof to show that there are special circumstances which justifies to deviate from this general rule.
Furthermore, the Tax Authority assumes that the rental income of up to 5 residential units is passive income.
In contrast, the rent of more than 5 residential properties and less than 10 residential properties will be examined according to the considerations outlined in the circular and the nature of the income will be accordingly determined as income from a business or as passive income.
One of the most important criteria is the frequency of transactions or activities. Hereby, not only the rental activity should be relevant but also additional activities like the setting up of lease agreements, marketing activities, the volume of accounting activities and the rent collection procedure. Another important criteria for the classification is whether there is a certain level of proficiency and knowledge required for the rental activity. Another factor to be considered is, the frequency by which the taxpayer carries out developments or improvements of the property. The more improvements to be done the more likelihood that the rental income is classified as business income. However, the tax authority emphasizes that the lack of developments and improvements does not negate the fact that the rental can be classified as business income. The tax authority note that the type of property, the financing method or the holding period are less critical in determining whether rental income is business or passive income.
After the decision of the Court of Appeals in the Biran case the Israeli Tax Authority released a draft circular, setting out the criteria according to which rental income will be classified in the future as business income or rental income. Whereas the Court of Appeals did not want to set a rigid quantitative threshold, the tax authority established that the rent of more than 10 residential units are to be considered business income, where the burden of proof of the contrary shifts to the taxpayer. The rent activity of up to 5 residential units is to be presumed passive income according to the draft circular. The classification of rental income of the lease of more than 5 but less than 10 residential properties will be determined by applying criteria like the frequency of activities (such as marketing activities, rent collection procedure, lease agreements), like the proficiency and knowledge required for the rental activity and like the volume of the development and improvements of the respective properties.
It is to be assumed that the Tax Authority will classify rental income as business income versus passive income on the basis of the above mentioned statements contained in the draft circular.