A Dentist Renting Out 12 Apartments in Jerusalem with Annual Income Over Half a Million Shekels: Business or Passive Income? The Court Rules

The rental income amounted to an average of 540,000 shekels per year, but the dentist claimed it was “passive income,” allowing for a 10% tax rate. Conversely, the Tax Authority argued that it constituted a business in every respect, requiring the payment of income tax. The District Court ruled.

By Adv. Almog Gilad, with assistance from legal researcher Anne Moati

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Three taxation tracks are available to individuals renting out apartments for residential purposes: the standard tax track, the 10% tax track, and the tax exemption track (up to a specified cap). However, when dealing with a large number of apartments, these will not be classified for tax purposes as “passive income” under Section 2(6) of the Income Tax Ordinance but rather as “active income,” rising to the level of a rental business as defined in Section 2(1) of the Ordinance.

Classifying rental income as “passive” or income from a “business” determines the applicable tax laws. “Passive income” typically arises from renting a property without significant business activity and benefits from lower tax rates (and, in some cases, exemptions). In contrast, “business income” generally stems from substantial, ongoing, cyclical, and systematic activity, requiring personal effort by the business owner or their representatives. “Business income” is usually subject to higher tax rates but allows for expense deductions. Passive income involves minimal involvement, while business income demands an ongoing investment of time and effort.

rental income israel
Adv. Almog Gilad, Gindi Caspi Law

This article reviews the District Court ruling, which addressed the dispute over classifying rental income from multiple residential apartments. The question was whether this rental activity qualifies as “passive income,” benefiting from lower tax rates, or as “business income,” typically taxed at higher rates.

Case Details:

This case involves a dentist who rented out 12 apartments in Jerusalem from 2012 to 2018. The rental income averaged 540,000 shekels annually. The appellant argued that the income was not from a “business” but was “passive” and subject to the 10% tax track under Section 122 of the Ordinance.

The dentist claimed that the income was not derived from a “business” but rather constituted “passive income,” and therefore, the applicable tax rate was under Section 122 of the Ordinance (the 10% tax track). Conversely, the Tax Assessor argued that the number of apartments rented out, their high value, and the fact that the appellant hired a company to manage all the apartments indicated that the income stemmed from personal effort and thus qualified as “business income.”

The appellant argued that the Jerusalem Tax Assessor relied solely on the number of apartments without considering other criteria established in 2018 by the Supreme Court in Civil Appeal 8236/16 Jerusalem Tax Assessor 1 v. Biran. These criteria include, among others, the method of property acquisition, duration of ownership, execution of property improvements, and the allocation of rental income. The appellant also stated that he is not actively involved in managing the properties, has not undertaken any development or improvement of the rented apartments, and spends no more than one hour per year on rental activities. Additionally, he claimed that the rental income was allocated for charitable donations and purposes, further supporting the argument that the income does not constitute “business income.”

Conversely, the Tax Assessor argued that, based on the same criteria, the conclusion is that the income constitutes “business income.” The number of apartments rented out, their high value, the fact that the appellant hired a company to manage all the apartments, and involvement in additional real estate transactions indicate that the income stems from personal effort and, therefore, qualifies as “business income.”

The Legal Question:

The central legal question under discussion is whether the rental income from the appellant’s numerous residential apartments constitutes “business income,” which would require tax calculation based on the appellant’s marginal tax rates (which could reach approximately 50%), or “passive income,” eligible for a reduced tax track.

Court Decision:

The court ruled that the appellant’s rental income constitutes “business income” rather than “passive income.” The fundamental principle is that a transaction should be assessed based on its nature and economic substance, with limited weight given to the taxpayer’s subjective intentions. The decision was based on the presence of an organized management mechanism for the properties, involving the investment of financial resources and time and the significant scale of activity in real estate (approximately 500,000 shekels annually).

The appellant’s argument that, if this were a “business,” the “business inventory” (i.e., the apartments) would have been purchased over a short period was deemed unfounded. In his case, the acquisitions were spread over a long time. According to the court’s ruling, the opposite is true: the nature of a business is to develop over time. The appellant’s intent to generate profits and his systematic investment in the activity indicates a business nature. Therefore, the totality of evidence and circumstances demonstrates that the rental income from the many residential apartments constitutes business income and should be taxed accordingly.

Author’s Note:

The ruling highlights the considerations that must be considered when classifying rental income (as established in the Biran case and in the draft position of the Tax Authority published afterward). Auxiliary criteria include the nature of the property, method of financing, duration of ownership, expertise, mechanism, frequency, financial scope, the entrepreneurship test, and the “umbrella test”—a circumstances-based test that examines all relevant factors that can aid in forming the distinction. The decision to classify the appellant’s income as “business income” underscores the importance of the criteria established in case law and the difficulty in determining the boundary between “passive income” and “business income,” as each case requires a thorough examination.

For this purpose, it is essential to be familiar with the applicable law, case law, and the draft position of the Tax Authority (which has not matured into an official position and according to which the rental of up to five private apartments would qualify for the reduced 10% track. Private individuals renting 5–10 apartments would need to convince the Tax Authority that they are eligible for the reduced track while renting 10 or more residential apartments would be classified as a “business”).

Additionally, choosing the tax track is not simple. This choice has significant implications (such as the right to deduct expenses, the method for determining capital gains tax applicable in the future when selling the property, and more). In some instances, there may be an advantage to choosing a tax track with a higher rate, which would result in a lower capital gains tax upon selling the property. For this reason, it is necessary to consult with professionals knowledgeable in the relevant laws.

(Jerusalem District Court Case No. 41419-02-22 Gedaliah Mordechai Stern v. Jerusalem Tax Assessor)

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The contents of this article are designed to provide the reader with general information and not to serve as legal or other professional advice for a particular transaction. Readers are advised to obtain advice from qualified professionals prior to entering into any transaction.

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