U.S. TAX SUMMARY
Tax Overview –Real Estate Investments in the United States
Income producing real estate investments in the U.S. (Commercial or residential) require income tax reporting and possibly income tax payment for both U.S. citizens and non-U.S. citizens. In this report, we will clarify the key issues involved.
During the life of your investment there are two types of income that will require reporting and tax:
- 1-Rental income
- 2-Capital gain on the sale of the property
Both types of income are subject to income tax in the U.S. and Israel.
Paragraph 7 of the tax treaty between Israel and the United States clarifies this point and established “First right to tax”, whereby in the case of an Israeli resident who owns an investment property in the United States, the “first right to tax” goes to the United States.
The State of Israel also has the right to require income tax reporting and payment on the properties according to the terms of the treaty signed between the countries (crediting the taxpayer for taxes paid in the U.S. to eliminate double taxation).
Income Tax on Rental Income in the U.S.:
The annual income tax forms reported to the U.S. include the income and expenses related to the rental property. This includes all direct expenses incurred by the property management company, as well as all indirect expenses incurred by the investor.
Direct expenses may include homeowners insurance, property tax, rental advertising, cleaning, painting, repairs, property management or broker fees, legal & accounting fees, etc.
Indirect expenses may include flight costs, hotels, car rental, food and lodging, etc.
It is advisable to save your receipts so that they can be presented to the IRS (Internal Revenue Service) in the event of an audit.
Property depreciation: U.S. law allows for 27.5 years of depreciation for residential rental property.
Federal (IRS) tax brackets for 2014 range from 10% to 39.6% (before exemptions) depending on your level of income in the U.S.
In addition to Federal reporting, some States require income tax reporting as well. For example: New York 4%-6.85% , California 1%-9.3%, Florida – no tax obligation , Nevada – no tax obligation , Texas – no tax obligation.
Capital Gains Tax in the U.S.:
When you sell your property, the sale must be reported on your annual tax return. If the sale results in a gain, it is subject to tax.
Capital Gain (or loss) is defined as the difference between the selling price less selling expenses and the depreciated value of the property.
The U.S. capital gain tax rate ranges from 15% to 20% for long term investments (more than one year) and from 10% to 39.6% for short term investments (less than one year).
Selling an investment property within a year of its purchase date is considered as ordinary income and will be taxed accordingly.
Keep in mind that certain states also require capital gains reporting and taxation.
Israeli Tax Reporting on the U.S. Rental Income:
An Israeli resident who earns rental income from real estate in the U.S. can choose one of the following options:
- 1-“Marginal Tax” option: - Under this option, the rental income will be considered together with your Israeli income, all allowable expenses will be recognized and you will pay income tax according to your tax bracket.
- Please be aware that the expenses will be recognized according to the laws and practices in Israel. Therefore, the Israeli taxable income may be different from the U.S taxable income. Additionally, the investor who chooses this option will have the tax he paid to the IRS in the U.S. deducted from the tax he will be required to pay in Israel (no double taxation).
- 2-15% Option - Under this option, the investor pays a flat 15% tax on the total rental income less depreciation.
- Under this option, the investor will not have the right to deduct any expenses nor the tax paid in the U.S.
The decision is purely mathematical, and the investor will choose the option that will allow him to legally pay the least amount of tax.
Capital Gains Tax in Israel on the Sale of a U.S. Property
Properties that were purchased after 1/1/2003 will be subject to Israeli capital gains tax of 25%.
The Israeli capital gains tax will be reduced by the capital gains tax the investor paid to the IRS in the United States. This means that the investor will pay the difference between what he paid in the U.S. (usually around 15%) and the required tax in Israel, therefore the total C.G. tax should not exceed 15%.
Deferring Payment of Capital Gains Tax – Property Exchange:
Both U.S. and Israeli tax authorities allow for a deferment (postponement) of paying C.G. tax in the event that the investor purchases another property at similar terms to the one he sold.
In the U.S., Section 1031 of the U.S. income tax code (IRC SECTION 1031) allows an investor to defer C.G. tax payment in the event that he purchased another property at the same or higher cost than the one he sold.
One can continue to sell and purchase other properties in this way thereby deferring payment of C.G. tax until the last property is sold off and none other purchased.
In Israel, Paragraph 96 is the section deals with the property exchange rules.
Please be aware that these sections are complex with numerous conditions that need to be adhered to.
The Investment and Tax Process – Step by Step:
Below is a brief summary of required or recommended activities for investors in U.S. real estate:
1-Decision to purchase rental producing properties in the U.S., connection with the proper sales/investment representatives.
2-Establish an LLC in the State in which you wish to invest.
3-Receive an EIN number for the LLC (for LLC tax identification).
4-Purchase the property through the LLC.
5-Rent the property and have it managed
6-In the year you purchase your property and every year that you own it, you will need to file a federal tax return to the IRS. This must be filed by June 15 of each year and an extension can be received up to October 15, and in extreme circumstances even further.
7-The LLC tax return (Form 1065) will include all the income and expenses related to the property and will allocate a Form K-1 to every investor and member of the LLC. The K-1 is the form through which the investor’s share of the LLC’s profit or loss is transferred from the LLC to the individual.
8-In addition to the LLC tax return, each investor will file an individual tax return which will include his portion of the profit or loss from the LLC according to the form K-1 he receives from the LLC.
9-In the first year that these forms are submitted, we will include Form W-7, which is the request for the investor to receive an ITIN number (Individual Taxpayer Identification Number). This is a required number that will be used each year for tax reporting and for banking identification. U.S. citizens who have Social Security numbers do not need an ITIN number.
Investors must file an LLC and individual tax return for each year that he owns the property in the U.S.
Inheritance tax is an obligation in the U.S. for both U.S. citizens and non-U.S. citizens and should be taken into account during estate planning.
The processes and procedures are complex and include many detailed regulatory aspects and it is not recommended that they be reported without professional assistance and consultation.
Our firm has offices in Israel and the United States servicing hundreds of clients (corporate, individual) and specializes in Israeli, International and American tax laws together with qualified legal partners. We also specialize in U.S. real estate investment taxation.
We look forward to being able to service your tax needs in Israel and the United States.
Please feel free to contact us at any time.
Ronen Marcovich, CPA
Eshel, Marcovich, Cohen, CPA
30 Six Day Blvd. (Champion Tower), Bnei Brak, 5120261