Taxation of Rental Income in the United States

In the United States, rental income is not always taxed under one single set of rules. The applicable tax treatment depends on how the property is used, whether the owner also uses it personally, and whether the activity remains passive rental activity or rises to the level of an active business.

For real estate investors in the United States, it is important to understand these distinctions. They affect the tax liability, the reporting method, the deductions that may be available, and sometimes also exposure to additional taxes when a U.S. property is owned by a resident of another country.

For Israeli residents, the picture is even more complex, since two different tax

systems must be considered – in the United States and in Israel

In general, rental activity can be divided into three categories:

• Regular rental activity
• Mixed personal and rental use, and
• Hospitality activity that rises to the level of a business

Regular Rental Activity

The first category is regular rental activity. This is the most common category, and it generally applies when the property is held for investment purposes and rented to tenants, while the owner’s personal use is limited or does not exist.

In most cases, the income is reported on Schedule E of the individual U.S. tax return. The basic tax principle is that the property owner is taxed on net rental income, rather than on the gross rent collected.

This distinction is important. Rental income for U.S. tax purposes includes more than monthly rent payments. It may also include advance rent, payments for canceling a lease, security deposits retained by the landlord, owner expenses paid by the tenant, and the value of services or property received instead of rent. Against this income, ordinary and necessary rental expenses may generally be deducted, including mortgage interest, certain taxes, insurance, repairs, management fees, advertising, professional fees, certain travel expenses, and similar costs.

One of the most important deductions is depreciation, which generally allows the cost of the building of a residential rental property, excluding the land, to be deducted over 27.5 years. As a result, a property may generate positive cash flow yet still show low taxable income or even a loss for tax purposes.

Therefore, the main tax consequences in this category are relatively straightforward: the activity will generally be classified as passive rental activity, reported on Schedule E, and generally not subject to self-employment tax. However, in certain cases, the passive activity loss rules may limit the ability to offset losses immediately. State or local income tax may also apply, depending on the location of the property.

Mixed Personal and Rental Use

The second category is mixed personal and rental use. This category applies when the owner also uses the property personally, either directly or through related parties.

The key test here is the 14-day or 10% rule: a dwelling unit will generally be treated as a residence if personal use exceeds the greater of 14 days during the year or 10% of the number of days during which the property was rented at fair rental value. If this threshold is crossed, the property is no longer treated, for all purposes, as a pure investment property.

This category is especially relevant to vacation homes and partial or short-term rentals. A property may be rented for part of the year and still be treated as a residence if the owner’s personal use is sufficiently significant. When a property falls into this category, tax treatment becomes more restrictive. Expenses generally must be allocated between rental use and personal use. The property owner cannot simply deduct all expenses as if the property were used solely for investment purposes. In addition, the ability to claim losses may be limited.

The Less Than 15 Days Rule

A special rule also applies when a residence is rented for less than 15 days during the year. In that case, the rental income is generally exempt from federal income tax, but the related rental expenses are not deductible as rental expenses. This rule is often relevant where a private residence is rented temporarily during a major event.

Business-Level Hospitality Activity

The third category is business-level hospitality activity. This is the category that creates much confusion in the short-term rental market, including Airbnb and similar platforms. Many property owners assume that a short stay automatically turns the rental into a business. However, the important question is whether the owner is merely making accommodation available to guests or also providing them with substantial services.

If the owner or manager mainly provides use of the property only, even if accompanied by ordinary turnover services such as cleaning between guests, coordinating repairs, or basic check-in logistics, the activity may still be treated as rental activity. By contrast, where the owner provides significant services for the convenience of guests, such as regular cleaning during the stay, linen changes during the stay, meal services, or hotel-like support, the Internal Revenue Service (IRS) may classify the activity as a hospitality business rather than passive rental activity.

The tax consequences in this case are materially different. When the activity is classified as a business or trade rather than passive rental activity, the income will generally be reported as business income and may also be subject to self-employment tax in addition to regular income tax.

This may significantly increase the overall tax burden. Therefore, operators of short-term rentals should analyze not only the length of each stay, but also the level of services actually provided.

Israeli Residents with Rental Income from U.S. Property

For Israeli residents who generate rental income from real estate in the United States, a more in-depth analysis is required. Under the tax treaty between Israel and the United States, income from real property is generally taxable first in the country where the property is located. In the case of U.S. real estate, this means that the United States has the primary taxing right, while Israel retains a residual taxing right. Therefore, an Israeli resident who earns rental income from a U.S. property will generally need to report and pay tax first in the United States, and then examine the Israeli tax implications.

U.S. Tax Treatment for Israeli Property Owners

The practical tax treatment in the United States depends on how the income is reported. In certain cases, foreign property owners may be subject to a gross-basis withholding tax regime with respect to U.S.-source income that is fixed or determinable, annual or periodical income. However, where the taxpayer makes the appropriate election to treat the rental activity as income effectively connected with a U.S. trade or business, the income may instead be taxed on a net basis, allowing deductions for expenses such as interest, taxes, insurance, repairs, management fees, and depreciation. In many cases, net-basis taxation is preferable to taxation on gross income.

Israeli Tax Treatment: Section 122A

From the Israeli perspective, an Israeli resident must also report the income in Israel. In general, two possible routes are commonly examined under the Income Tax Ordinance. The first is the 15% gross-basis tax route under Section 122A, which generally applies to rental income from outside Israel on a gross basis, with only limited deduction rights, mainly depreciation, and without a foreign tax credit mechanism. The second is the ordinary net-income route, under which the taxpayer is taxed at the applicable marginal tax rate, may deduct relevant expenses, and will generally also be entitled to claim a foreign tax credit for taxes paid in the United States.

The choice between the Israeli routes depends heavily on the specific circumstances. A taxpayer with high-deductible expenses, significant depreciation, or substantial taxes paid in the United States may prefer the ordinary net route. By contrast, a taxpayer with relatively low expenses may consider whether the gross route is simpler or more efficient. Therefore, the treaty and the foreign tax credit rules are a critical component in preventing double taxation, but they do not eliminate the need for careful planning.

TaxLink – Our Story

TaxLink is an accounting firm specializing in both U.S. and Israeli taxation. Our practical experience with the Internal Revenue Service (IRS) and the Israel Tax Authority, together with an in-depth understanding of the interaction between the two systems, enables us to build an end-to-end solution tailored to your specific case.

Most clients who contact us do so because they are required to file reports in the United States – whether this involves Form 1040, Foreign Account Tax Compliance Act (FATCA) reporting, Foreign Bank Account Report (FBAR) filings, or investments in U.S. real estate. We manage the process as a coordinated cross-border matter, with the aim of reducing errors, avoiding duplications, and helping prevent double taxation, all within the framework of U.S. law, Israeli law, and the tax treaty between the United States and Israel.

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