Legislation changes concerning REITs as a result of amendment act no. 222 in tax law

The recent inauguration of amendment act no. 222 in Israeli tax law has brought significant changes in legislation on REITs (Real Estate Investment Trusts) in Israel and has introduced a new term to the tax law – Rental Housing Real Estate Investment Trust. In this article we will elaborate on the main changes that came into action with amendment act no. 222 concerning REITs (Sub sections 64a2 through 64a11) and their effects on the Israeli real estate market.

Background

In 2005 Israeli government introduced amendment act no. 147 to the tax law, which first established a special consideration to REITs in Israel. However, the legislation only concerned income producing business real estate and was full of limitations and restrictions on REITs. Therefore, it was considered somewhat of a failure with only two REITs being established in Israel – “REIT 1” in 2006 and “Sela Capital” in 2008. The primary investors in both REITs are insurance companies and institutional entities such as pension funds.

Due to an increasing crisis in the housing market in Israel and to the fact that only two REITs were established since amendment act no. 147, an Inter-Ministerial Committee was initiated including the ministry of finance, Israeli securities authority and the tax authority. The committee purposed to use REITs as a possible solution to the housing crisis in Israel, and so as part of amendment act no. 222, significant changes were made in REIT legislation and the new term “Rental Housing REIT” was introduced in order to attract entrepreneurs to increase the supply of rental apartments and to assist in resolving the housing crisis.

Rental Housing Real Estate Investment Trust

Amendment 222 introduces a few new terms, as the main innovations concern rental housing REITs. Here are some of the new definitions:

The governmental company for rental housing inc. – The Company “Dira Lehaskir” (translated as “Apartment for rent”) is a governmental company established in 2013 and among its responsibilities is the planning and execution of rental housing projects. The company was ordained as one of three exclusive entities that can propose plans to the committee of preferred housing areas, whose main objective is to rapidly increase the housing supply and to create a supply of long term rental housing.

Rental Housing Real Estate – Real estate that is purchase in order to become income producing real estate (the assumption is that it is purchased as land which is later built on), or five years after the purchase by a REIT (the earlier of the two), and if the following conditions are met:

• The real estate was purchased in an auction published by the government or by the governmental company for rental housing, and its terms dictate that at least half of the apartments will be designated to rental housing for at least 15 years.
• There is an approved plan to turn the real estate into rental housing.
• The real estate was marketed by the governmental company for rental housing with the purpose of making it rental housing for at least 15 years. This purpose must be insured by a contract between the governmental company for rental housing and the REIT that buys it.
• The REIT has bought or constructed at least 20 housing units in one compound within five years since its purchase, in accordance with the governmental company for rental housing and it was approved that the units will serve as rental housing for at least 20 years.

Changes in legislation concerning REITs

Amendment 222 introduced significant changes not only through new terms and definitions, but also by changing the existing laws.

The most significant change concerns the definition of a REIT. According to amendment 222, a REIT is a company which complies with the following (Sub section 64a3):

• The company is incorporated in Israel, and is managed in Israel.
• Enlisted in the Israeli stock exchange within 24 months (before – 12 months) since its incorporation. In addition, if within 36 months since its incorporation, the company has rental housing assets that are worth 30% or more of all its asset value, the enlisting period is extended to 36 months. From the time of enlistment, the company’s stocks must be traded in Israel.
• Since it is incorporated, the company will have no assets, activity, income, expenses, losses or commitments that are not strictly tied with its activity as a REIT.
• Assets that are passed to the company do not comply with instructions of “Part E2” (structural changes and mergers) or with clause 70 of the real estate taxation law (conditioned exemption for certain sales to unions).
• On the 30.6 and 31.12 of every year since the company is incorporated until it is enlisted it must comply with the following conditions:
  1. The worth of its assets that are income producing real estate, rental housing real estate, bonds, loans, deposits, cash and clients (as defined by accounting principles) is at least 95% of all the company’s assets.
  2. The worth of its assets that are income producing real estate and rental housing real estate is at least 75% of all its assets.
• On 30.6 and 31.12 of every year since the company is enlisted it must comply with the following conditions in addition to the conditions mentioned before:
  1. The worth of its assets that are income producing real estate and rental housing real estate is at least 75% of all assets and at least 200 million NIS.
  2. The sum of all loans taken by the company will not be more than 60% of the assets that are income producing real estate that is not rental housing, in addition 80% of the assets that are for rental housing and 20% of the other assets.
• The law sets three dates that refer to holding percentages – 3 years since first enlisting, 5 years since first enlisting and 8 years since first enlisting. On the first date (3 years) the law states that there will be no less than five shareholders that hold over 70% of all the rights in the company. On the second date (5 years) there will be no less than five shareholders that hold over 50% of all the rights in the company and one shareholder cannot hold more than 30% of the rights in the company. On the third date (8 years) one shareholder cannot hold more than 20% of the rights in the company.

Income from REIT (Sub section 64a4) – Here amendment 222 introduces changes concerning rental housing REITs. In general, this sub section determines that for tax calculation the income produced by a shareholder from a REIT (such as dividend) will be viewed by the tax authorities as income produced by the shareholder himself. The amendment adds that income produced from a rental housing REIT will be taxed at 20% and not according to individual taxation rules. In addition, income from selling short-term real estate (as defined by sub section 64a2) will be taxable in accordance with sub section 126 (corporate tax).

Another significant change inflicted by amendment 222 refers to taxation on capital gains from transferring real estate and reduced purchase tax for REITs during their incorporation (sub section 64a7): in this sub section we are introduced to a new term – “real estate transfer”. The definition for this is the transfer of real estate to a company that later becomes a REIT in exchange for stocks, with a few conditions such as:

• The transfer has taken place before the company became public.
• All rights in the real estate were transferred to the company.
• The ratio between the market worth of the shares and the worth of all the company shares immediately after the issuing is the equivalent of the market worth of the real estate.

This change states that it is possible to transfer real estate to a REIT in exchange for private issuing of stocks. That allows the REIT to accumulate assets quickly and without having a large primary capital.

The sub section states that a real estate transfer will be charged with purchase tax of 0.5% of the real estate worth. If there was an additional compensation for the real estate that is more than 50% of all the return (stocks and additional compensation), the payment will have a purchase tax of 0.5% of the part of the real estate that the stocks were exchanged for, and purchase tax will be as defined in real estate tax law for the remainder.

Sub section 64a7 refers to a reduced purchase tax for rental housing real estate. It states that the company will be charged only with the 0.5% purchase tax as long as it complies with the pre-mentioned definition of rental housing real estate (sub section 64a3).

Implications and effects on the Real Estate market and rental housing

When amendment act no. 147 was first introduced in 2005 and presented the REITs to the Israeli market, the main objective was to allow individuals with small savings to purchase rights in real estate and enjoy the return on their investment directly. In reality, due to strict governmental regulation, this did not happen and was even deemed unprofitable, and therefore the institutional entities are the ones who took over the investments. With amendment 222 and the relief it applies to regulations, we hope that the original objective behind the introduction of REITs will occur and private investors will put their money on REITs.

The changes introduced by amendment act no. 222 of the tax law are expected to have a vast influence on both the real estate market in general and the rental housing market in particular. Due to the removal of major restrictions on REITs, we anticipate the incorporation of new REITs in the coming years, which will be key players in the development of the real estate market in Israel.

The most important change is set to occur in the rental housing market. Today this market consists mainly from private renters and a hard supply. The innovations, presented by amendment 222 concerning rental housing, will allow the entry of new companies into the market, causing a wider competition and ultimately have an increase in the rental housing supply and better apartments since it will be mainly new housing projects. These changes will stabilize the market since, as defined in sub section 64a3, in order to comply with the definition of a rental housing REIT, the real estate must be designated for rental housing for at least 15 years.

Written by: Michael Lulko – Audit Department