Finance Ministry's Plan to Cool Down the Real Estate Market: Treasury Wants to Cancel Existing Tax Exemptions for Investing in Apartments

The Finance Ministry is going after real estate investors by working on a plan to cancel the existing tax exemption on the profits from the sale of a second (or third or fourth) home. This would leave the tax break only for homeowners who sell their primary residence and only home.

The treasury's budgets division, headed by Udi Nisan, has prepared an extensive plan - apparently without the participation of the Israel Tax Authority - to cancel the exemption for betterment tax (mas shevach) on additional residences. The change, which is expected to bring the treasury an extra NIS 1 billion to NIS 1.5 billion per year in tax revenues, would significantly hurt the income of those members of the Israeli upper class who have made real estate their prefered investment vehicle in recent years.

The treasury's revocation of the exemption is expected to meet with fierce opposition from various professionals involved in the real estate sector, such as lawyers, property assessors and accountants.

There will most likely be a grace period, so as not to cause a massive sell-off of homes in one year, which would shock the real estate market. In any case, the cancellation of the exemption would not be retroactive.

The treasury is leaning toward making the change as early as January 2011.

The new system would mean that any profit made on the property from the date the exemption is canceled would be taxed. Any profits before that date would remain exempt.

Today, the law requires home sellers to pay tax on the profit they made on the investment. The tax is 20% of the real, inflation-adjusted profit, similar to the capital gains tax for financial investments.

But in practice, Israeli homes have turned into a tax haven, and private housing has become a tax shelter. The total betterment tax collected in 2009 was only NIS 180 million, though the Israeli real estate market is worth tens of billions of shekels annually.

The various tax exemptions on real estate investment have grown over the years. They started with the exemption on the sale of a first home, as the state did not want to tax people for improving their standard of living. But the exemptions took off from there.

First homes can be sold tax-free once every 18 months. Second homes can be sold once every four years, with a full exemption on the profits. You can also sell two small apartments to buy one big one - tax-free. Apartments received as a gift or inheritance from relatives are also exempt from betterment taxes when sold.

All these tax breaks have made the betterment tax ineffective, and almost no one ends up paying it. This has created a massive tax shelter for the wealthy, turning real estate into an almost tax-free investment. Besides the issue of sharing the tax burden, these exemptions have also distorted demand in the real estate market and driven prices up.

The budgets division, in an attempt to lower real estate prices and expand the availability of affordable housing, is now trying to change the situation.

The new plan will allow all citizens to own one home, their primary residence, tax-free. Any other homes will be taxed when sold. The homeowner will be able to decide which is their primary, tax-free residence - and can change the designation and transfer it to another property at any time. The tax rate will remain 20%.

However, these changes only apply to betterment taxes on the profits made on the sale of homes and apartments. In practice, buying and selling homes in Israel is far from tax-free. There is also a purchase tax of up to 5% on the purchase of a home.

Yehuda Nasradishi, the head of the Tax Authority, told TheMarker that the 3% to 5% tax usually paid on the purchase of a new home, which is paid in advance on the entire purchase price, is the equivalent of a 20% tax on the profits made on a home over 10 to 15 years. However, the budgets division does not accept Nasradishi's explanation, saying the purchase tax is much less fair than a tax on profits.

In addition, the purchase tax does not reduce demand for housing or lead to lower prices, making the tax economically inefficient, says the treasury. The budgets division has not ruled out lowering the purchase tax in the future to balance out the changes in the betterment tax.

Some say they object to the change because it will lower the viability of rental housing and reduce the number of rental apartments on the market. To counteract this effect, the treasury is considering increasing the NIS 4,500 monthly exemption for rental income by up to NIS 1,000 per month. Other solutions are also being considered.