What are Israel's 'tax traps' for gifts, inheritance?

A transfer of an asset, whether as a gift or inheritance, to an Israeli resident recipient is not subject to Israeli taxation. However, upon the sale of the asset by the recipient to a third-party, the recipient may be subject to Israeli capital gains tax on the entire appreciation in the asset’s value – from the date it was originally acquired by the transferor and until the date it was sold by the recipient.

This is known as the “continuity principle.” It leads to Israeli tax on the gain before and after the asset entered the recipient’s possession. This assumes the recipient was not exempt due to the aliya 10-year Israeli tax holiday for foreign income and gains. So, what would be the outcome if an Israeli resident receives a gift or inheritance from a non-Israeli resident? Tax traps!

If an Israeli resident recipient receives a non-Israeli asset as a gift or inheritance from a non-Israeli resident, a question arises: Should the recipient be taxed on the entire increase in asset’s value even though such increase partly accrued in the hands of the non-Israeli transferor? 

After all, while the asset was held by the non-Israeli transferor, the asset was presumably outside the Israeli tax net, so why is the increase in asset’s value during this period subject to Israeli taxation? Putting the Israeli recipient in the place of the non-Israeli transferor shouldn’t matter. 

Nevertheless, the Israeli tax law blindly applies the continuity principle. Consequently, many Israeli residents who received assets from non-Israeli residents who are unaware of this “tax trap” may pay excess tax to the Israeli Tax Authority (ITA).

Moreover, this “tax trap” can also lead to double-taxation, as the increase in asset’s value may have already been subject to tax in the transferor’s country of residence.

Olim and senior returning residents (who lived abroad 10 years or more) are entitled to an Israeli tax exemption upon the sale of their non-Israeli assets for a period of 10 years from their arrival date to Israel.

If such assets are not sold during the 10-year period, a linear (pro rata) Israeli tax exemption may apply, meaning that only the calculated increase in the asset’s value after of the 10-years period and onward is taxed, while the increase in the asset’s value attributable to the period from the asset’s original purchase date to the end of the 10-years period should be tax exempt.

However, what happens if an oleh or a senior returning resident decides not to sell the asset but instead transfer it by way of a gift or inheritance to his/her Israeli resident children born in Israel? 

Under the dry letter of the Israeli tax law the children will pay capital gains tax on the entire increase in the asset’s value – from the date it was originally acquired by the oleh or senior returning resident to the date it was sold by their children. 

This result can be painful and in certain cases the lack of proper tax planning can turn a full tax exemption to a full tax liability.

These unwanted tax traps may be avoided with advance planning and preparation in all countries concerned. 

If an asset is to be transferred to an Israeli recipient, it may be advisable to consider stepping up the cost basis of the asset to market value upon its transfer to the Israeli recipient. 

With the new stepped-up cost basis, an increase in the asset’s value attributable to a non-Israeli resident transferor may not be subject to Israeli tax, but check whether any foreign tax liability is generated.

The step-up may be achieved by applying for an Israeli tax ruling, or recording a sale of the asset, or possibly in other ways. 

An Israeli tax step-up ruling may be applied for on a special form and will be subject to various conditions. At the practical level, some ITA officials do not fully comprehend the principles involved, so perseverance may be needed.

As always, consult experienced tax advisers in each country at an early stage in specific cases.