Recognition of Undocumented Construction Costs for Capital Gains Tax in Israel

The Israel Tax Authority (ITA) recently published an addendum to the 1987 circular  with the goal of minimizing disputes with sellers of residential apartments. The addendum contains procedures addressing instances when sellers failed to retain documentation of their apartments’ construction expenses, but apply to deduct these expenses from their capital gains tax upon selling the property.

At issue are instances when a person purchased land, constructed a residence on it and, decades later, decides to sell it. In principle, construction costs are deductible expenses, and their deduction could significantly reduce the capital gains tax payable upon selling the property.

In order for construction costs to be deductible, the seller must present evidence that he actually incurred and paid for these expenses. The problem is that most people do not meticulously retain receipts and tax invoices over decades.

In the past, this issue was less significant, since most residential apartments were sold with an exemption from capital gains tax by virtue of a provision of the Real Estate Taxation Law that allowed sellers to sell an apartment at any price once every four years with a full tax exemption.

After this exemption was rescinded, the most common tax exemption is the exemption from capital gains tax on the sale of a sole residential apartment at a maximum value of about ILS 5 million. As a result, the number of apartments that are sold with a full capital gains tax exemption has dropped significantly.

Although awareness of the need to retain documentation of construction costs has increased over the years since 2014 (when the exemption from capital gains tax once every four years was rescinded), there are still many instances when sellers failed to retain proper documentation. This situation has led to numerous disputes between sellers and the ITA about recognition of construction expenses for the purpose of calculating capital gains tax when they sell their properties.

The ITA’s new rules take a more lenient approach towards sellers

The ITA now differentiates between residential apartments constructed prior to January 2014 and those constructed after January 2014, and takes a more lenient approach towards apartments constructed prior to 2014, when there was less awareness of the need to retain documentation as specified above.

New rules for sellers

If a seller failed to retain documentation of his apartment’s construction costs, the ITA inspector will estimate the costs based on his experience, using accepted price lists. If the ITA is convinced that the seller actually incurred these expenses and improved the apartment (and did not deduct these expenses pursuant to the Income Tax Ordinance), it will allow the seller to deduct these expenses, according to the following procedure:

• Ÿ The seller must attach a special form to the transaction report, which specifies the construction expenses that he wants to deduct, along with an explanation about the year of his construction expenditures and any other documentation that could support his application (if any), such as checks, documentation of bank transfers, documentation of cash withdrawals and deposits, agreements signed with professionals, a real estate appraiser’s appraisal that was used in order to obtain insurance or a loan, the performance contractor’s declaration attesting to execution of construction works, etc.
• ŸThe ITA inspector handling the application will schedule a visit to the property.

If the seller succeeds in substantiating the construction expenses to the satisfaction of the the ITA inspector by completing the above procedure, the seller will be allowed to deduct the construction expenses in the following manner:

• ŸIf the construction was completed before January 1, 2014 – the total construction expenses requested will be deductible within the framework of the tax self-assessment.
• ŸIf the construction was completed after January 1, 2014 – the construction expenses requested will be deductible within the framework of the tax self-assessment, excluding VAT and excluding contractor’s profit at the rate of 15%.

If the seller is unable to meet the burden of proof, the tax ITA inspector will follow these rules:

• ŸIf the construction was completed before January 1, 2014 – the total construction expenses based on the accepted price lists in the construction industry will be deductible, excluding VAT and excluding contractor’s profit at the rate of 15%. In exceptional instances, the ITA inspector may demand a CPA’s approval that the seller did not and will not deduct these expenses pursuant to the Income Tax Ordinance or during the sale of another property. If the seller cannot issue such a CPA approval, only 2/3 of the construction expenses will be deductible.
• ŸIf the construction was completed after January 1, 2014 – if the seller issues a CPA’s approval that the construction expenses were not and will not be deducted pursuant to the Income Tax Ordinance or during the sale of another property, 2/3 of the construction expenses according to the price list will be deductible, excluding VAT and excluding contractor’s profit at the rate of 15%. If such a CPA approval is not issued, the seller must submit valid reasons for not issuing it and, if he is unable to do so – the construction expenses will not be deductible.

To summarize: the ITA’s rules take a lenient approach towards sellers who failed to retain documentation of the construction costs they incurred when building their apartments, provided that they follow particular procedures to help them bear the burden of proof of the sum of the construction expenses they actually incurred.

Prior to these new rules, the ITA allowed sellers to deduct construction costs without receipts, based on an appraiser’s assessment of the construction costs. These appraisals were based (as the new procedure states) on accepted price lists in the construction industry and on visits to the property. In some instances, the new rules may make the need to obtain appraisals superfluous, which will also make life easier for sellers selling apartments.