The Japanese taxation of real estate income for individuals

November 9, 2010  |  Individual, Real Estate

Snowmen made by visitors to Sato Land, an amusement center near Sapporo in Hokkaido.

Expatriates coming to work in Japan will frequently maintain a property in their home country and hence may have to address how Japanese tax applies to rental or other income they earn from the property concerned.  If the property is sold while they are in Japan they may also have to address the Japanese taxation of any capital gain or loss arising on the sale.  An expatriate may also earn rental income from buying an investment property in Japan.

This is article is intended to help expatriates resident in Japan understand how income from real estate is taxed.

Japanese real estate taxation can be a complicated area and professional advice should always be sought from a qualified Japanese tax accountant based on the actual facts of a particular case. However this and related articles on the site should help an expatriate in Japan have an informed discussion with their tax advisor on the main Japanese tax issues that can arise.

Threshold issues

There are a number of ‘threshold issues’ that an individual should first address in order to understand whether or not they have a liability to Japanese tax on their real estate income.

If the individual does have a liability to tax on their real estate income then the income should be reported on their tax return and subject to marginal tax rates according to the process discussed in this article on the preparation of a Japanese individual tax return.

Threshold issues to consider include:

  • The scope of real estate income as defined for Japanese tax purposes

  • Individual tax residence in Japan and its relation to the taxation of Japanese real estate income.

  • Distinguishing ‘real estate income’ from ‘business income’ arising from running a real estate business.

  • Fiscal transparency:  When real estate is not held directly by an individual but indirectly through an entity such as a partnership or trust that owns the real estate, the nature of the entity may impact the Japanese tax treatment of any income earned from the real estate asset concerned.

  • ‘Real estate income’ versus ‘capital gains from real estate’:  Certain transactions can give rise to income that is taxed as capital gain rather than as recurring income.

Japanese tax law principles that apply to the calculation of real estate income apply regardless of whether the real estate is located in Japan or overseas. Given that law and market custom overseas may differ from Japan, interpretation of how the principles apply to non Japanese transactions may often be required.

These issues are discussed further in the relevant sections below. Immediately below is a brief introduction to issues arising in the calculation of real estate income.

Practical issues in calculating real estate income

Assuming an individual is earning real estate income that has to be reported on his annual Japanese tax return, the next step is to consider in greater detail how such income is calculated.  Issues here include:

  • The timing of real estate income recognition (including income from ‘key money’, ‘guarantee money’ and other occasional sources of real estate income that are a feature of the Japanese real estate market)

  • Deductible expenses for real estate income purposes:  Interest, depreciation, maintenance or improvements to the property.

  • Offsetting of losses arising from real estate, including limitations on the deduction certain interest and other payments.

  • International tax issues;  Credits of foreign taxes against Japanese income taxes, the application of tax treaties, issues arising from foreign exchange conversion and similar.

Where a link appears in the above list, please access the related article for more details.
 

Real estate tax schedule with English translation

Individual tax schedule

Please click on this link for access to an the non blue form tax return schedule typically used to report real estate income and on this link or the diagram to the right for a link to its English translation.

Looking at the schedule, note that the front side includes sections for disclosing real estate revenues and necessary expenses while the reverse includes a section to calculate tax deductible depreciation that includes the opening balance, amount claimed and closing balance for carry forward to the following year.  The form also includes sections to provide sundry information on maintenance and similar necessary property expenses.
 

Scope of real estate income

Real estate income for Japanese individual tax purposes (in Japanese ‘不動産所得’ or ‘fudousan shotoku’) is defined broadly and includes income from the rental of:

  • real estate
  • rights over real estate
  • boats, shipping
  • aircraft

The taxation of income from the leasing of shipping and aircraft is not discussed further in this article other than for the editor to note his understanding that, in the past, the ability to offset overall losses arising on real estate against other sources of income may have encouraged investment in schemes where the underlying asset was ships or aircraft subject to accelerated depreciation.

Limitations on the offset of losses arising from partnerships may have curtailed investment activity that relied on the availability of such a tax benefit.
 

Individual tax residence and real estate income

The Japanese taxation of the income of an individual depends on the residence status of the individual concerned and whether or not the income concerned has a Japanese source.

The source country for income from real estate will almost without exception be the country in which the real estate is located.

Income from real estate located in Japan which has a Japan source is subject to Japanese tax regardless of the tax residence of the individual recieving the income.

Non Japanese source real estate income from assets located outside Japan is taxable for any individual who is tax resident in Japan unless the individual has ‘non-permanent resident’ status.  Japanese nationals and expatriates who have lived in Japan for more than the five years will, in general, not have had or will have lost their ‘non-permanent resident’ status and hence be taxable on world wide income including non-Japanese source real estate income.

Non-permanent residents of Japan are taxed on non-Japan source income (including non Japanese source income from real estate outside Japan) only to the extent the income concerned is paid in or remitted into Japan.  Non permanent resident individuals will tend to be expatriates who have not previously lived in Japan for up to their first five years or so of residence in the country.

 

More complex issues

Three more complex threshold issues are discussed below:  The taxation of real estate activity conducted on a scale sufficiently large to be treated as a business, the implications of holding real estate through a partnership or other entity rather than holding it directly and the treatment of some lease transactions as giving rise to capital gain.

These three issues can have important tax planning implications.  However expatriates who, for example, own directly just one or two homes that they are renting out on a monthly basis back in their home country may wish to pass over the more detailed discussion of these issues below as they may not be of relevance to them.

 

‘Real estate income’ versus ‘business income’

When preparing their tax return, an individual earning income from real estate should consider whether or not the scale of the income earning activity concerned is large enough to be considered a business in its own right.  Treatment of such activity as a business will alter the way in which the income is calculated as discussed below, although the income concerned is still treated as real estate income for Japanese tax purposes.

The website of the Japanese National Tax Authorities (the ‘NTA’) includes a series of short guidelines (below ‘Tax Answers’ or ‘TA’s) explaining the NTAs view on this and other real estate tax issues.

TA 1373 (link in Japanese) addresses under what circumstances activities giving rise to income from real estate may be treated as a business in their own right.  It states that whether or not such activity would be treated as a business activity depends, in principle, on whether the level of activity is such that, applying normal social norms, it would be treated as a business.

Fortunately this rather unhelpful definition is supplemented by comments in TA 1373 saying that the NTA would normally regard the renting of ten or more rooms or separate apartments or five or more separate family homes as being a business.

Differences in taxation as a business

TA 1373 also lists up some of the differences between how real estate income is calculated when treated as income from a business (below, when treated as ‘Business Scale Real Estate Income’) compared with the more common case of real estate income not treated as a business.

Disposal of fixtures and fittings

The expenses of removal or disposal of fixed assets that are rented out can be treated as a deductible expense for Business Scale Real Estate Income in the year incurred.  However, for other real estate income the deduction is limited to the amount of net real estate income before deduction of the losses on such assets.

Bad debt deduction

Where a loss arises through the non payment of rental income due then, for Business Scale Real Estate Income, the related bad debt is treated as a deductible expense in the year incurred.  For other real estate income the related revenue is treated as not having been earned on the day in the year that it became due. 

For individuals earning income other than Business Scale Real Estate Income this rule may mean, in practice, re-opening old closed tax returns to reclaim taxes when a bad debt arises (although this would only be possible provided the time limit for re-opening the returns has not passed).

Blue or white tax return deduction for dedicated employees

The tax law allows a deduction against Business Scale Real Estate Income for amounts of salary paid to certain family members of the taxpayer, such as their spouse, for assistance in the business concerned.  This may be a benefit under some circumstances if, for example, the marginal tax rate of the family member receiving such a salary is lower than that of the taxpayer.  This deduction is not available for other, non-business scale real estate income.

Special deduction for blue form tax return filers

A ‘blue form’ tax return filer may be able to claim a tax deduction of up to JPY650,000 against Business Scale Real Estate Income when certain conditions are met.  Such a ‘blue form’ special deduction is limited to JPY100,000 for blue form filing individuals earning other, non-business scale real estate income.

 

Real estate income from trusts and partnerships


Complexity in Japanese taxation can arise when, rather than receiving income from holding real estate directly, an individual is receiving income from a partnership or a trust (below, from an ‘Entity’) that owns the underlying real estate concerned.

Meaning of fiscal transparency

When real estate (or other assets, although these are not discussed here) is not held directly but through an Entity then a determination has to be made as to whether or not the Entity is ‘fiscally transparent’ for Japanese tax purposes.

If the Entity is ‘fiscally transparent’ then, effectively, the existence of the Entity is ignored for Japanese tax purposes, the assets and liabilities concerned are deemed to be held directly by the owners of the Entity and the owners are treated as if they had earned the underlying income or incurred related expenses of the Entity directly.

If a fiscally transparent Entity makes an overall loss on from its real estate activities in a given year then, in contrast to the position when owning the real estate directly, certain conditions may have to be met in order for individual owners of an interest in the Entity to be able to offset the tax loss against other income.  This issue is discussed in the context of corporate owners of a nin’i kumiai (a commonly used Japanese real estate investment entity) in this article.  While the issues for individuals are similar to those of a corporation, proper tax advice should be obtained when these circumstances apply.

Entities treated as corporations

If an Entity is not fiscally transparent then the Entity would likely be treated as a corporation for Japanese tax purposes and amounts received by individual owners of the Entity deemed to be either income from dividends or a return of Entity capital.

The tax treatment of dividends or return of capital is very different from real estate income and hence it is critical to determine whether or not the Entity is fiscally transparent or not.

Articles here give some further background to dividend taxation.

Determination of fiscal transparency

The ‘fiscal transparency’ status of Japanese entities under standard Japanese commercial arrangements has already been decided as a matter of Japanese tax practice.  This article discusses the Japanese fiscal transparency status of various entities.

For foreign partnerships and other foreign entities the determination of whether or not the Entity concerned is fiscally transparent can be much more difficult.  In theory, a comparison should be made between the foreign law under which the entity is formed and corresponding Japanese law to determine whether or not the foreign entity resembles a fiscally transparent Japanese entity.  However such a comparison can be very subjective, subject to differing interpretation and with the final conclusion around tax status uncertain.

In practice the status of foreign entities as fiscally transparent entities or, alternatively, as corporations is subject to considerable uncertainty with little published guidance, although the NTA indicated under some circumstances that US Limited Liability Corporations would be treated as corporations rather than fiscally transparent entities as discussed in this article.

Given the above an individual investing in a foreign entity should speak to a qualified Japanese tax accountant to help understand its status for Japanese tax purposes.

 

Capital gain


Japanese tax law recognizes that the lease of a property over an extended period for a payment that is significant when compared to the value of the property shares the economic characteristics of the disposal of the property, and hence income from such a transaction may be treated as giving rise to capital gain with very different (and possibly beneficial) tax treatment.

Leashold transactions

Where a person receives a lump sum for the establishment of a long term leasing right (in Japanese a ‘借地権’ or ‘shaykuchi ken’ and referred to below as a ‘Specified Lease’) then, if the transaction meets specified conditions including the consideration for the establishment of the Specified Lease being at least 50 per cent of the value of the property, the transaction may be treated as giving rise to a capital gain.

Lump sum prepayments

Japanese tax law also recognizes that a payment may be made under a Specified Lease that is not sufficiently large, compared to the value of the property, to be treated as giving rise to a capital gain but which may instead economically have some of the characteristics of a pre-payment of future rental income.  Such payments may not immediately be taxed as income in the year received by amortized into income over a longer period.  Qualified tax advice should be taken about the details of the calculation if this situation arises.


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