Tax Relief on Foreign Real Estate Sales

When the Sale of Foreign Real Estate May Not Be Fully Subject to Capital Gains Tax in Israel

The sale of real estate located outside Israel by an Israeli resident may give rise to tax liability both in the source country – the country where the property is located – and in Israel. This creates a risk of double taxation. However, Israeli law, and the tax treaties to which Israel is a party, provide mechanisms designed to address this difficulty, so that the sale is not fully taxed as a capital gain in Israel.

The relevant legal framework is not uniform in every case. It is affected, among other things, by the type of property, the manner in which it is used, the nature of the legal right held, the holding structure, the applicable foreign law, and the existence of a relevant tax treaty.

Sale of a Foreign Residential Apartment

Where the property is a residential apartment located outside Israel, which is actually used for residential purposes and not to generate income or profit, there may be an argument that its sale should not be fully subject to capital gains tax in Israel. In some cases, there may even be an argument that the capital gains tax regime does not apply.

The starting point under Israeli tax law is that the imposition of tax requires a clear and express legal basis. The question of whether the sale of a property outside Israel is taxable in Israel is examined first and foremost under the specific statutory provisions that apply to the transaction.

For this purpose, several key layers should be considered:

• As a general rule, the Real Estate Taxation Law, 1963, deals with rights in real estate located in Israel. Therefore, in most cases, it is not the main legal framework for analyzing the tax treatment of the sale of an apartment located outside Israel.
• At the level of the Income Tax Ordinance, Part E of the Ordinance, which deals with capital gains, must be examined, and in particular the definition of the term “asset” in Section 88 of the Ordinance. This definition also includes an exception concerning a “right of possession in real estate used for residential purposes and not for earning income or profit.”
• Accordingly, in certain cases, the issue is not limited to whether there is a tax exemption. Rather, there is a more preliminary and fundamental question: whether the right being sold falls, from the outset, within the scope of the taxable event that applies in Israel.

The practical meaning of this exception depends on the overall circumstances, including the manner in which the property is used, the nature of the right held, the law that applies in the target country, the legal holding structure, and the ability to prove a sufficient factual basis to the Israel Tax Authority.

What Is a “Right of Possession” and Why Its Legal Classification Matters

As a general rule, “possession” describes control and actual holding of a property, while the legal right to hold it may arise from various sources, such as ownership, lease, protected tenancy, a co-ownership agreement, trust, or another legal arrangement.

Therefore, for purposes of legal classification, and particularly for tax purposes, it is not enough to rely on the label given to the right or on the way the parties described it commercially. It is necessary to examine the legal source under which the property is actually held, the substantive nature of the right under the applicable law, and whether the right is proprietary, contractual, or part of another arrangement. This analysis may have a direct impact on the classification and tax analysis in Israel, especially where the property is located outside Israel and involves legal structures that do not necessarily correspond to Israeli law.

The Importance of Foreign Law and the Tax Treaty

Alongside Israeli law, it is also necessary to examine the domestic law of the target country and the provisions of the relevant tax treaty, if one exists. In some cases, the local law of the target country grants an exemption, relief, or tax deferral on the sale of a private residential apartment or another asset, subject to the conditions set out in that law. In other cases, the tax rate in the target country may be high, so that the practical effect of tax planning in Israel will be more limited.

A tax treaty does not necessarily create an exemption. However, it may regulate the allocation of taxing rights between the countries and serve as a central tool in analyzing foreign tax credit issues, reducing double taxation, and, in some cases, interpreting the application of Israeli law to the relevant income.

Income-Producing Real Estate Abroad and Like-Kind Exchanges – Key Considerations

Where the foreign property is not used as a private residence but is instead used to generate income, such as a property held for rental purposes, different tax issues arise. One of the central issues in this context is the possibility of deferring tax through an exchange of assets.

A “like-kind exchange” is a mechanism under which an asset is sold and the proceeds from the sale are invested in the purchase of a replacement asset used for the same economic purpose. The rationale underlying like-kind exchange mechanisms is that, in such cases, there is not necessarily a full economic realization in the sense of withdrawing funds for free use. Instead, the investment continues in a replacement asset. In Israel, Section 96 of the Income Tax Ordinance includes a certain mechanism for tax deferral in defined cases, including with respect to depreciable assets. However, as a general rule, this mechanism does not apply to exchanges of real estate located outside Israel.

By contrast, the target country may have local law that allows tax deferral upon an exchange of assets. In such a case, a mismatch may arise between the timing of the tax liability in Israel and the timing of the tax liability in the foreign country.

Timing Mismatch Between Israel and the Foreign Country

Where the target country allows tax deferral through a like-kind exchange, but a taxable event arises in Israel already at the time of the initial sale, a significant practical difficulty may arise: the taxpayer may be required to pay tax in Israel before any tax has actually been paid in the foreign country. In such a situation, at the time of payment in Israel, a foreign tax credit may not always be available, since the credit depends on foreign tax having actually been paid and on the fulfillment of additional conditions under the law.

This timing mismatch may materially affect cash flow, reporting, and the structure of the transaction. It therefore has practical importance in planning the transaction in advance.

Key Points to Review in Advance

• Whether the property is a private residential apartment or an income-producing asset.
• What the nature of the legal right held in the property is under local law.
• Whether the property is held by an individual, company, trust, or another legal structure.
• Whether there is a relevant tax treaty between Israel and the target country, and what its implications are.
• Whether tax has been or will be paid in the foreign country, and when that payment is made.
• Whether the conditions for claiming a foreign tax credit in Israel are met.
• Whether the structure of the transaction creates timing mismatches or cash-flow difficulties that require advance preparation.

Where the property is held through a company, and not directly by an individual, the tax implications, credit rules, and relevant settlement mechanisms must be examined separately, since the rules that apply to individuals will not necessarily apply in every case.

It should also be remembered that the foreign tax credit in Israel is subject to the limitations of the law, including the principle that, as a general rule, a credit cannot be claimed in an amount that exceeds the Israeli tax applicable to the same income.

In conclusion, the taxation of the sale of foreign real estate by an Israeli resident is a complex area that requires an integrated review of Israeli law, foreign law, and the relevant tax treaty. In certain cases, there may be an argument that the sale is not fully subject to capital gains tax in Israel. In other cases, the focus of the analysis will be the foreign tax credit, timing mismatches, or the implications of a like-kind exchange.

Because the tax outcome is directly affected by the type of property, the manner in which it is used, the holding structure, the target country, and the relevant legal documents, each transaction should be reviewed individually, in advance, and before any action is taken or any report is filed.

Nimrod Yaron & Co. specializes in Israeli and international taxation. Our team consists of professionals with many years of experience at the Israel Tax Authority, together with experience at leading firms and law offices, bringing an integrated legal and economic perspective. We advise private and public companies, Israeli and foreign companies, global venture capital funds, and clients seeking focused advice in clear and accessible language. We also work with a professional network of accounting firms and law offices around the world, enabling us to provide comprehensive support in cross-border matters.

When it comes to the sale of real estate outside Israel, we assist with reviewing tax exposure in Israel and in the target country, analyzing the application of tax treaties, examining foreign tax credit options, reviewing the appropriate holding structure, and advising on transactions with complex international characteristics.

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