U.S. real estate income taxation at the tip of the fork

# Entrepreneur of the Week Post Number 2 -

Good morning dear entrepreneurs and investors,
After introducing myself in the previous post and knowing a little about my background today I would like to put some order in current tax matters when an Israeli investor generates real estate income in the US.
Important note! This is an overview of the tax environment in Israel and the United States and should not be considered as advice before making an investment
For most investors, one of the first questions that arises at the stage of examining the viability of investing in real estate in the United States is "How much tax do I pay?"
In my opinion, in the first stage (and even before the tax question arises) you must decide whether the investment is worthwhile for you? That is, in existing circumstances will your money be able to achieve an excess return (before tax) elsewhere?
If you answered this question with “no” you can move on to the next step and ask yourself what the right asset is for me depending on the budget constraints and the level of risk you are willing to take in this type of investment.
Once you have successfully gone through the first two steps of the process and decided on the type of property, budget limit and level of risk you can move on to an examination of the expected tax burden on income from investing in real estate in the US.
First an order is made as to who belongs to whom and when.
The Income Tax Ordinance, the Tax Convention and the American Code stipulate that in the case of the generation of income from real estate in the United States, the initial taxing right will belong to the state in which the real estate is located. This means that in the case of real estate investment in the United States, the primary tax right belongs to the United States and the residual tax right belongs to Israel.
Why is it important and worthwhile to file a U.S. tax return on real estate income?
In general, U.S. real estate rental income from foreign investors is classified by the U.S. Code as FDAP (Fixed, Determinable, Annual, or Periodical) income that is subject to a uniform 30% tax on gross income. This is the reason why there are management companies that are not willing to transfer rent money to you without an ITIN number and if you have already managed to convince them to transfer the money to you, they deduct 30% tax from your gross income.
In order to avoid a situation where you pay tax at a rate of 30% on your gross income, you must submit an American tax return and ask to treat the income from the U.S. as effective (Connected Income (ECI)), ie the income generated in the U.S. related to the business or trade Operation in the United States is therefore entitled to a deduction for all expenses related to the generation of income. In order to enjoy this option, an orderly statement must be made in the first tax return submitted to the United States authorities.
Once you have made the selection, you will be able to recognize all the expenses incurred to generate the income from the tax return and deduct it from the taxable income, so that you will pay tax on the net annual profit.
In the case of rental income, the investor will pay federal tax in the U.S. according to the total income derived from the U.S., starting at the first dollar and at rates of between 10% -37%.
In addition to paying federal tax, tax must also be reported and paid in the state where the property is located. State tax rates vary from state to state and range from 0% to about 12%, depending on the total income of the investor originating in that state.
In this regard, it is important to note that an Israeli resident must file an annual report and tax on his income from abroad, even in the case where the income was received in a US bank account or held for you by the asset management company and the money was not transferred back to Israel.
The previous law refers us to section 122A of the Income Tax Ordinance in Israel, which deals with the manner of taxation of income from abroad produced by a resident of Israel. In accordance with this section, you can choose one of the following two reporting routes each year:
Gross route - In accordance with this route, a uniform tax rate of 15% will apply to the taxpayer's gross income. In this case, the taxpayer will be able to deduct only his taxable income from depreciation expenses, in this route there is no recognition of tax expenses paid in the United States for the purpose of reducing tax expenses in Israel.
Net track - In accordance with this track, the taxpayer will be able to recognize all expenses related to generating income from tax in the US and pay tax on his net income abroad while receiving a tax credit for federal tax and state tax paid in the US. The tax rate on income in this track will be the marginal tax rate of the taxpayer, but not less than 31%.
The taxpayer can choose each year the optimal route for him and there is no restriction on switching between the routes.
Capital gain:
In the United States, there is a distinction between short-term capital gain - for an asset purchased by the investor and sold in a short period of time and long-term capital gain - for an asset purchased by the investor and sold within a long period of time. This distinction is critical for the purpose of calculating the capital gains tax applicable to the investor when selling the property.
While short-term capital gains in the United States will be classified in the United States as income taxable under the investor's marginal tax (0% -37%), long-term capital gains are eligible for tax brackets of 0% / 15% / 20% (depending on the rest of the income of The investor originating in the United States).
By the way, when calculating the capital gain in the US tax return, the depreciation expenses previously required for the property sold (and previously deducted taxable income) are also taken into account, these expenses are classified as Unrecaptured Section 1250 Gain that are taxable at up to 25% in the US.
In this regard, it is important to note that capital gains arising from the sale of a real estate property in the United States by an individual resident of Israel will be liable in Israel at a tax rate of 25% (or 28% if the investor is subject to VAT), tax paid abroad will be taxable in Israel Therefore, as long as the investor does not reach a weighted tax liability (federal + state) in the US that exceeds 25% (or 28%), he is in fact indifferent to the question of whether it is a short-term or long-term capital gain *.
* Regarding my last sentence, it is important to reserve my words and write that the reference and tax rates I mentioned are correct when it comes to a passive investor and not an active investor.
In a very general way and without going into too much depth, since it is possible to write a post on this subject on its own, income tax has established a number of tests that may see the investor as liable to marginal tax on income generated from capital gains. The assessee. Among the main tests prescribed for this purpose are the test of the frequency of execution of transactions, the test of the holding period, the existence of an ongoing mechanism and activity, the test of knowledge and proficiency, etc.
This is for today friends, hope you have learned and learned about the main aspects of taxation that apply in the US and Israel when making a real estate investment in the US. I will summarize the post in three main points that are very important to me that you understand and take with you further:
A single investor in the United States who is a resident of Israel must report and tax his income from real estate abroad, regardless of whether he returned the money to Israel or not.
As Israelis when you look at the issue of tax do not just look at how much tax you will pay on income in the US only and should look at the total tax rate, in the US and in Israel, starting with the income from the investment.
Tax is paid only on profits! Therefore, first of all, invest your efforts in finding the most affordable and profitable deal for you, once you have found it you will be able to examine how much tax you will pay and under what circumstances.
The above is not presented as a substitute for professional advice from an accountant and is only general information, which does not constitute binding professional advice and should not be relied on in any way. Any action taken according to the information and details stated in this post is the sole responsibility of the user. The purpose of this post is to help readers expand their personal knowledge base only and allow them to know more, before turning to an accountant or any other expert.