A few months ago, a client contacted us. She is a U.S. citizen living in Israel and had sold a plot of land that had been owned by her family for decades. The transaction had been completed and Israeli land appreciation tax had been paid, so from her perspective, the tax matter was closed.
This is a common question among U.S. citizens and residents who own property in Israel. In many cases, it only comes up after the sale has already taken place, once tax has already been paid in Israel. However, not every sale of Israeli property gives rise to an NIIT liability, and each case must be examined based on its specific facts.
U.S. citizens and residents are taxed in the United States on their worldwide income, even if they live in Israel and even if the property sold is located in Israel. Therefore, the sale of real estate in Israel may also be a taxable event in the United States.
NIIT is a separate federal tax from capital gains tax, imposed at a rate of 3.8%. It may apply to net investment income, including certain gains from the sale of real estate. The fact that the property is located in Israel does not, in itself, exclude the gain from the scope of the tax.
Not Every Gain from the Sale of Property Is Subject to NIIT
To determine whether NIIT applies, the first step is to examine whether the gain is classified as investment income. Where the gain arose in the course of a non-passive business activity of the taxpayer, the treatment may be different.
Therefore, the way the property was held, the nature of its use, whether it was used in a business activity, and the overall circumstances of the transaction are all important.
Income Thresholds
NIIT applies only when income exceeds certain thresholds:
- $200,000 for an individual
- $250,000 for married taxpayers filing jointly
- $125,000 for a married taxpayer filing separately
The test is based on Modified Adjusted Gross Income (MAGI), including certain adjustments relating to the foreign earned income exclusion under Section 911 of the U.S. Internal Revenue Code. The tax is imposed on the lesser of net investment income or the amount by which income exceeds the relevant threshold.
Exclusion for the Sale of a Principal Residence
The tax exclusion for the sale of a principal residence under Section 121 may also apply to a home in Israel, if the ownership and use tests under U.S. law are met.
Where the gain is excluded under Section 121, it is generally not included in net investment income for NIIT purposes. By contrast, in the sale of a vacant plot of land, the exclusion will usually not apply, unless the sale is connected to a residence and the relevant conditions are satisfied.
Identity of the Seller and Ownership Structure
The identity of the taxpayer and the ownership structure are also significant. A spouse who is not a U.S. citizen or resident is not subject to NIIT. In addition, the filing status, an election under Section 6013, and ownership through a trust or estate may affect the result.
In some cases, examining the identity of the seller and the ownership structure provides the answer before it is even necessary to analyze the foreign tax credit issue.
The Gap Between Israeli Land Appreciation Tax and the U.S. Gain Calculation
In the sale of long-held assets in Israel, a significant gap can sometimes arise between the taxable gain in Israel and the taxable gain in the United States.
In Israel, land appreciation tax is calculated after inflation adjustments and, in some cases, by applying historical tax rates. In the United States, by contrast, the gain is calculated in dollars and based on historical cost that is not adjusted for inflation.
A property purchased in the 1970s or 1980s may generate a relatively low taxable gain in Israel, but a higher gain in the United States. Exchange rates may also increase the gap: the purchase cost is translated into dollars using the exchange rate on the purchase date, while the sale proceeds are translated using the exchange rate on the sale date.
As a result, the Israeli land appreciation tax paid does not necessarily eliminate the U.S. tax exposure, including the exposure to NIIT.
Can a Credit Be Claimed for Israeli Land Appreciation Tax?
Under U.S. domestic law, the generally accepted position is that a direct foreign tax credit cannot be claimed against NIIT. A foreign tax credit under Section 901 of the U.S. Internal Revenue Code applies to taxes under Chapter 1 of the Code, whereas NIIT is governed by Chapter 2A.
The result may be payment of Israeli land appreciation tax alongside an additional NIIT liability in the United States, without a direct credit.
Can the Israel-U.S. Tax Treaty Help?
According to the position of the U.S. Internal Revenue Service, tax paid to a foreign country is generally not available as a direct credit against NIIT. The reason is that, under U.S. law, NIIT is classified as a tax that is separate from regular income tax, and therefore the regular foreign tax credit mechanism does not automatically apply to it.
In recent years, this issue has been addressed in several U.S. court decisions. The common question in those cases was whether a tax treaty between the United States and another country can require the United States to take into account foreign tax paid, including in relation to NIIT.
In Toulouse, which involved a claim under the U.S.-France tax treaty, the Tax Court rejected the claim for a foreign tax credit against NIIT. The court held that the treaty’s credit provision was subject to the limitations of U.S. domestic law. In Kim, the arguments that NIIT is, in substance, a Medicare tax and that foreign tax can be credited against it were also rejected.
By contrast, in Bruyea, which involved a taxpayer who sold real estate in Canada and paid Canadian tax, the U.S. Court of Federal Claims accepted the taxpayer’s position. The court held that the application provision in the U.S.-Canada tax treaty could also apply to similar taxes imposed after the treaty was signed. It further held that the fact that NIIT is located in a separate chapter of the U.S. Internal Revenue Code does not, in itself, deny eligibility for a treaty-based credit.
The case law does not establish a uniform rule, but it does raise the possibility of examining treaty-based arguments in appropriate cases. In the Israeli context, Article 26(1) of the Israel-U.S. tax treaty is drafted in a structure that is, to some extent, similar to the provision discussed in Bruyea. This may provide a basis for an argument, but it does not lead to an automatic conclusion.
The Israel-U.S. treaty is not identical to the U.S.-Canada treaty. Therefore, in each case, it is necessary to examine the wording of the treaty provisions, the list of covered taxes, the relationship to Israeli land appreciation tax, the relevant protocol provisions, and whether the Israeli treaty contains anchors similar to those that assisted the taxpayer in Bruyea.
Can Action Be Taken After NIIT Has Already Been Paid?
Possibly. In refund claims based on a foreign tax credit, the statute of limitations may be longer than the ordinary limitations period. Therefore, a person who paid NIIT in recent years following the sale of a property in Israel may still be able to examine the options available.
However, before entering into a dispute over the credit or the treaty, it is important to first examine whether NIIT applied in the first place. The classification of the gain, the income thresholds, possible exemptions, and the identity of the taxpayer may result in no tax liability arising at all.
In summary, the sale of a property in Israel by a U.S. citizen or resident requires a broad review of the tax implications in both countries. The nature of the property, the ownership structure, the way the gain is calculated in Israel and in the United States, the identity of the seller, the reporting method, and the provisions of the tax treaty should all be examined.
It should not be assumed in advance that NIIT applies to every sale. At the same time, it should also not be assumed that Israeli land appreciation tax paid eliminates the U.S. tax liability.
Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team is made up of professionals with years of experience at the Israel Tax Authority, together with experience at leading firms and law offices, bringing a combined legal and economic perspective.
We advise private and public companies, Israeli and foreign companies, global venture capital funds, and private clients seeking focused, clear, and practical advice. Through a professional network of accounting firms and law firms around the world, we provide comprehensive support in cross-border matters as well.
Sold a property in Israel and are you a U.S. citizen or resident? We would be happy to review your U.S. tax exposure, the NIIT implications, and the available options regarding foreign tax credits and the tax treaty.
Frequently Asked Questions
Is a U.S. citizen subject to NIIT when selling a property in Israel?
Not necessarily. The liability depends on the classification of the gain, total income, possible exemptions, the ownership structure, and the identity of the seller.
What is the NIIT rate?
The tax rate is 3.8%. It applies to the lesser of net investment income or the amount of income above the relevant threshold.
Does Israeli land appreciation tax paid provide an automatic credit against NIIT?
No. Under the generally accepted position in U.S. law, the foreign tax credit does not apply directly to NIIT, subject to possible treaty-based arguments.
Can the exclusion for the sale of a residence in Israel also apply in the United States?
Yes, in certain cases. Section 121 may apply to a home in Israel, subject to satisfying the ownership and use tests for a principal residence.
Can a refund claim be filed after NIIT has been paid?
Possibly. This depends on the circumstances of the case, the basis for the claim, and the applicable limitation periods for the return and the refund claim.
