Exemption from tax on a property received as an inheritance from abroad - approval for step up in income tax | Israeli resident | tax on capital gains.
Inheriting a property raises questions related to Israeli taxation, international taxation, and money laundering. Sometimes these questions arise from a desire to sell the property and sometimes from banks refusing to transfer the money into the country.
The discussion about the future capital gains from selling the properties is a small part of the process of realizing an inheritance from abroad. This process begins with legal, economic, and accounting examinations of the properties abroad—checks conducted by an accountant or tax consultant.
Tax planning regarding their realization according to the interface between local law and Israeli law, proving the source of the funds, and assisting in transferring the inheritance proceeds to Israel while minimizing taxes and expenses are crucial.
The tax authority has introduced the possibility of receiving tax rulings (pre-rulings) in advance for events that may have significant tax implications, such as purchases, sales, mergers, or splits of companies, loans, public offerings, etc. Some of these paths are considered “green tracks,” meaning they do not require prior approval from the tax authority, only reporting. Despite this, the tax authority often invites representatives for discussions even on submissions that were supposed to be part of the green tracks.
One of the most important tracks relates to tax exemption concerning a property received as an inheritance from abroad. Sometimes, a property received as an inheritance is subject to high tax—both in the country of origin (the country of residence of the decedent) and in the heir’s country. Some tax treaties help solve some of the issues, but without going through a process with the tax authority, the sale of the property will incur full capital gains tax on the entire sale proceeds (since the cost basis is zero!).
Since Israel does not have an inheritance tax (a tax that naturally applies to the heir) and does not have an estate tax (a tax that naturally applies to the estate or the decedent), economic logic requires establishing a new cost and acquisition date for the property received as an inheritance.
The acquisition date is supposed to be the day of the decedent’s death, and the cost is supposed to be the property’s value at the time of inheritance. It is always necessary to ensure that the tax treatment is minimal both in the country of the decedent and in Israel, but this article will only refer to the taxation that applies (or will apply in the future) in Israel.
Form 905 on the green track—step-up, refers to a common issue where a property abroad is given as a gift or inheritance to an Israeli resident by a non-resident. Receiving a property as a gift or inheritance does not constitute a taxable event, but when an Israeli resident comes to sell it, they will be forced to pay capital gains tax. The core of the issue is how the tax payment in Israel for the sale will be calculated and how the tax payment can be significantly reduced.
The “continuity of tax” principle
Section 88 of the Income Tax Ordinance, establishes the principle of tax continuity or tax preservation. This principle states that when an Israeli resident receives a property as a gift or inheritance, they essentially step into the shoes of the gift-giver or decedent, and the law sees them as if they were the original purchasers themselves. This means that the value of the property at the time of sale will be estimated to be its original cost when the decedent or gift-giver purchased it.
For example, suppose an Israeli resident inherited an apartment in the United States that was purchased by the decedent in 2018 for $800,000. Three years later, the Israeli resident sells the apartment he received as an inheritance for a million dollars. The principle of tax continuity dictates that the resident will be liable for capital gains tax on a total amount of $200,000—the profit, and therefore capital gains tax will be imposed on him. The principle mentioned in the example is logical, but to obtain approval for the acquisition date and purchase cost—an active step needs to be taken against the tax authority, and it is not always simple.
If the step-up approval is not received, the taxpayer will be required to pay capital gains tax for a theoretical profit of a million dollars, thus paying an amount of $250,000, a higher amount than all the profit accumulated in the apartment.
What is the proposed solution for the issue of capital gains?
Income Tax allows a request for a pre-ruling on the issue through the Step-up mechanism. The request stipulates that the tax authority will see the heir or gift recipient from a non-resident as if they had purchased it according to its current market value on the day of receipt. Thus, in practice, capital gains tax in Israel will be imposed on the sale of the property only on its growth in value from the day of receiving the inheritance or gift.
The request is submitted by a representative through Form 905 (see the attached link below).
It is advisable to submit the request as soon as possible after receiving a property as an inheritance or a gift. The disputes that arise during the discussions on the request usually revolve around the following issues:
- Valuation of the property at the time of receipt;
- Establishing a “new” acquisition date according to the law in the country of origin or in Israel;
- The issue of offsetting losses from the transferred assets or part of them;
- The position of the tax authority is not to approve a step-up for a non-marketable asset;
- A request for a step-up submitted significantly late – there is no certainty that it will be accepted. The tax authority may view this as a situation where the taxpayer decided not to perform a step-up and changed their decision after a certain period based on the circumstances (akin to a mistake in the feasibility of the transaction).
- Often, discussions are held regarding the depreciation required by the decedent and other issues.
As part of the tax ruling (pre-ruling), the heir is required to comply with several restrictions, including that a loss generated from the sale of the property will not be allowed for offset. Also, losses incurred by the heir or gift recipient before the day of death, or before the day of receiving the gift, will not be allowed against profits generated as a result of selling the property received as an inheritance or gift. In addition to the restrictions regarding the offsetting of losses, the tax ruling will determine that no depreciation for tax purposes is allowed for the property.
Link to the form:
To conclude, receiving property as a gift or inheritance from a non-resident can involve significant tax implications at the time of sale if not properly prepared in advance.
Although it seems like a simple process at first glance, there are many issues related to it that are uncertain and heavily dependent on litigation against the tax authority, and it is important to seek assistance from a tax expert.
Our office specializes in tax consulting, tax planning, and obtaining tax rulings from the tax authority, handling complex inheritance cases- contact us for more information!
