Property investors may lose tax breaks in real estate reforms

The Israeli government may soon begin collecting higher taxes from homeowners with rental property investments if proposed real estate reforms move forward in the Knesset over the coming months.

The changes aim to tackle Israel’s overheated housing market by targeting second-home owners, or investors, whose rental income from residential properties is tax-exempt if the rent is no more than NIS 5,470 ($1,552), according to current tax rules.

The new government’s draft Economic Arrangements Bill — which determines how funds are allocated from the national budget — suggests the government should reduce current tax exemptions on rental income for private landlords, whose numbers have fluctuated over the past two decades but have consistently trended up. In 2022, Tax Authority figures showed that 13% of Israeli households own two or more properties that they rent out to tenants, up from 3.2% of households in 2003.

For these investors, rental income of over NIS 5,470 may be taxed at up to 31%. And if rental income (even if it comes from more than one property) tops NIS 10,940 ($3,100) in total, the entire amount is subject to tax. In recent years, this figure has risen in line with inflation — currently at 5.4%.

By gradually eroding the tax-free amount, an increasing proportion of rental revenues will fall within the scope of regular income taxation. In turn, this can add billions of shekels of additional contributions to channel into a housing budget.

The original tax exemption was introduced in the 1990s when large numbers of immigrants from countries in the former Soviet Union began arriving in Israel. There was a need to encourage property owners to rent out apartments rather than keep them empty, to increase the supply of rental homes in the market.

The tax break continues to encourage rentals in place of empty apartments, in a market in which the population that has no choice but to rent is growing steadily. But the favorable tax treatment also incentivizes bricks-and-mortar property investments, which in turn takes homes out of the market as primary residences, and drives up prices.

Other forms of real estate investment are treated much less favorably. Income from real estate funds, or real estate share dividends, attracts a tax of at least 25%. These less direct forms of investment have also not delivered the substantial capital gains of bricks-and-mortar property investments, with housing prices having risen on average across Israel by 17.1% over the last year.

There is a meaningful risk that increasing tax on rental income may push rental prices up further, as landlords simply pass on increased costs to renters. Rental prices are already high and rising faster than the inflation rate, at an average of over 8% year on year.

The cost increases for new rental contracts — rather than extensions to existing tenancies — are likely even higher

Some of those renting out a property do own only one home. Often this is because they cannot afford to buy a home outright in the area in which they want to live, and therefore buy in a cheaper area, renting out the place they own as a way to get onto the housing ladder at an affordable cost.

The draft legislation makes clear that the government wants to recognize this group of property owners as a separate group from other landlords, and to allow them to benefit from tax-exempt rental income up to a higher level of NIS 7,500 (about $2,130) per month.

Other proposed real estate targeted measures include a special tax on the purchase of an investment apartment (one that is in addition to a primary residence). Purchase tax for investment purchases jumped from five percent to a minimum of eight percent in the fall of 2021, although this increase seems to have had little long-term effect in slowing down the rise in house prices.

There has also been talk of bringing in changes for short-term rentals (such as those marketed through Airbnb), to treat them as businesses and to create a level playing field in tax terms with hotels.

Elsewhere in the financial framework put forward, there are provisions that would allow local municipalities to increase local property taxes (arnona) for residences to encourage residential construction.

At the moment, municipalities generate higher revenue from taxing properties zoned for business and commerce than residences. This means that every new housing unit built represents lost income, particularly in comparison to commercial use of the land. This may incentivize home-building at the local level, but the plan will increase housing costs for both property owners and renters (who are typically responsible for paying local property taxes), feeding directly through to higher inflation and a higher overall cost of living.

These proposals aim to increase tax revenues from Israel’s residential real estate, growing the pot of money available to spend on building much-needed new homes. But they are most unlikely to reduce housing prices. That remains the goal for the newly convened housing cabinet, which has committed to delivering proposals to increase the affordability of housing in Israel, but has yet to start working.