Date: 19990729
Docket: 98-429-IT-I
BETWEEN:
PRASAD S. APTE,
Appellant ,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
(Delivered orally from the Bench at St. Catharines, Ontario, on June 10, 1999)
Mogan J.T.C.C.
[1] These appeals are for the 1994 and 1995 taxation years and the issue is whether the Appellant may deduct in computing income, certain losses which he sustained through the ownership of a rental property in the City of Kingston, Ontario.
[2] The Appellant has a doctoral degree in science and works as a research scientist. In 1985, he moved from Ottawa to Kingston to take up a position with Alcan, one of the large corporate employers in the City of Kingston. At that time, the Appellant and his wife purchased a dwelling at 24 Seaforth Road for a price of $112,000. They moved into that house and it was their family dwelling until the summer of 1991. In the fall of 1990, the Appellant was approached by a corporation in Edmonton, specifically, the Sherritt Corporation, and offered a position in that city in connection with his scientific background. There were protracted negotiations over the winter of 1991.
[3] In March of 1991, the Sherritt Corporation sent a letter to the Appellant, defining the terms of his engagement for employment in Edmonton. The Appellant found those terms acceptable and in mid-March 1991, accepted the employment on the basis that it would begin in July or August. The Appellant had a period of about three months to wind down his affairs in the City of Kingston. At that time, he and his wife could have sold their home anticipating the purchase of a new home in Edmonton, but they attended a seminar on financial planning and one of the suggestions was that a person should consider owning real estate as part of an investment portfolio. Since the Appellant and his wife already owned the dwelling on Seaforth Road, they made a business decision to retain that dwelling as an investment.
[4] They did put it on the market to test the price and actually received an offer of $167,000 which is $50,000 more than the original purchase price of $112,000, but they had listed the property at $199,000 and were satisfied that it was worth more than $167,000. Since it had gone up significantly in value in the intervening five or six years, they decided to keep the property as an investment and rent it out for rental income and to continue owning it, notwithstanding their move to Edmonton. Their determination to own the property is evidenced by the fact that in the terms of his engagement with the Sherritt Corporation in Edmonton, it agreed to pay for four trips (two by the Appellant and two by his wife) to Kingston over the next two years for the purpose of supervising or monitoring the administration of their investment property.
[5] In April 1991, they found a tenant connected with the Canadian Military who agreed to rent the property at $850 per month. However, in May 1991, that tenant cancelled the arrangement because he could obtain less expensive accommodation at the Armed Forces' base in Kingston. The Appellant and his wife let it be known that the property was for rent, and found a tenant among the workers at Alcan. The tenant was a person known casually to the Appellant but not a close friend. The Appellant said the tenant was the kind of person he might have seen from time to time on the Alcan premises and might have said hello to him once a week, but it was not through any particular friendship or close association that he rented the property to this tenant. It was just a fact that the tenant found out that the property was available, and it was particularly attractive to employees of Alcan because it was within a 10-minute walk of the Alcan plant. In any event, an agreement was struck and the property was leased to this tenant effective the end of the summer 1991.
[6] It was suggested in argument by counsel for the Respondent and suggested in cross-examination that this was a lease-to-purchase arrangement, but the Appellant totally rejected that suggestion. I find his evidence believable and there is no evidence on behalf of the Respondent to contradict the Appellant's sworn and believable evidence that it was not a lease-to-purchase situation. That may have been in the mind of Revenue Canada when they issued the assessment, but there is absolutely no evidence to support that.
[7] The Appellant moved to Edmonton sometime in the summer of 1991 so that his children could begin a new school year in Edmonton. Ever since the decision was made to retain the Kingston property, the Appellant knew his family would be moving to Edmonton, because he had accepted the Sherritt employment agreement in March 1991, and they knew they would be needing a dwelling in Edmonton. At that time, they increased the mortgage on the Kingston property. There are no documents in evidence pertaining to that mortgage but the Appellant stated that he thought they had increased the mortgage by $60,000 or $70,000. In the summer of 1991, it was a five-year mortgage with interest at 11% per annum which was renewable in the summer of 1996. I regard the increase in the mortgage as a truly significant event for reasons set out below.
[8] The Appellant stated that he had done a cash-flow analysis and anticipated losing money in the first few years because it is a well-known concept that in business, a person can expect what are called "start-up losses" until such time as the operation is running smoothly and revenues can exceed expenses. There were losses and those losses are the very reason for this appeal.
[9] The Respondent entered into evidence copies of the Appellant's income tax returns for 1992, 1993, 1994, 1995 and 1996. I will refer to some of the information from those returns. I do not regard the 1996 return as relevant because the Appellant and his wife determined in 1996 that they would sell the property. They negotiated with London Life concerning the refinancing of the mortgage and were told that a new mortgage could be obtained at 5½% per annum which is precisely one-half of the interest rate on the mortgage which was obtained in the summer of 1991. If they had refinanced at that much lower interest rate, the Appellant was satisfied they would have earned a profit, starting in January 1997 in the range of $90 to $120 per month. So there could be an anticipated profit of $1,200 in 1997 if that mortgage had been refinanced.
[10] The Appellant and his wife, however, took other matters into consideration. One was the fact that the real estate market in Kingston had actually gone down rather than going up. Where this property had been valued at approximately $190,000 to $200,000 in 1991, it was revalued in the spring of 1996 and they decided to put it on the market. I believe it sold actually for the price of $152,000.
[11] Therefore, in a sense, one may say that on an historical basis, the Appellant had realized a gain of approximately $40,000 from his 1985 cost to the 1996 proceeds of sale. But, having regard to the change of use from a family dwelling in the summer of 1991 when it had a value of $190,000 to a rental property for the next five years, in that context the Appellant can be said to have suffered a loss because from 1991 to 1996, the value of the property dropped by approximately $40,000 from something in the range of $190,000 to $152,000.
[12] The Appellant stated that he consulted with Revenue Canada, and obtained a small publication called a "Renter's Guide" which describes the circumstances in which rental income will be computed. It is his complaint that until he was reassessed disallowing the losses for 1994 and 1995, he had never heard of the phrase "reasonable expectation of profit". His complaint is that Revenue Canada does not alert any prospective property owner who is holding property as an investment that the losses may be disallowed on that basis. That may be a valid criticism. I have not seen this publication by Revenue Canada and it may be misleading to that extent but I am not in a position to say.
[13] For the past 20 years, the concept "reasonable expectation of profit" has been important in the computation of business income, ever since the Supreme Court of Canada issued its decision in Moldowan v. The Queen, 77 DTC 5213. It may not be known to the ordinary taxpayer but the concept of "reasonable expectation of profit" is certainly well-known to Revenue Canada and to every knowledgeable tax advisor in Canada since 1977.
[14] I turn now to the actual amounts involved. The Appellant was able to rent this property at $850 per month. He said in his Notice of Appeal that: "The maximum possible rent was sought for the property". That is a statement admitted by the Respondent in the Reply to the Notice of Appeal and the Appellant again repeated it in oral testimony. I found the Appellant to be totally credible. I have no hesitation in believing him when he says that was the best rent that could be obtained. It was no friendly deal with a fellow employee of Alcan and $850 per month was the going arm's length fair market rent for a property like his house on Seaforth Road. He obtained that rent in the years we are concerned about. The amount of $850 per month would produce annual rent of $10,200.
[15] For the first couple of years, or at least for the first year, the Appellant was required to pay a percentage of the rental income to the real estate agent who obtained the tenant. Therefore, the actual rent recovered in each year, at the beginning, was less than $9,000 by reason of the portion of the rent that was regarded as a commission which was in the range of 10%.
[16] I shall review for each of the four years (two years preceding the years under appeal, 1992 and 1993, and the two years under appeal, 1994 and 1995), the rent as reported in the Appellant's tax returns as reflected in Exhibits R-1 to R-4. The returns are showing the gross rent and I have identified the two highest expenses and lumped the others expenses together.
[17] In 1992, the rent was $9,800, the expenses claimed were interest on the mortgage of $12,297, property taxes of $3,067 and other expenses, for a total of $16,514. When those expenses are applied against the gross rent, it produces a loss of $7,214. In 1993, the rent was $9,720, expenses were interest on the mortgage of $12,185, property taxes of $2,917, and other expenses, for a total of $16,368. When those expenses are applied against the gross rent of $9,720, it produces a loss of $6,648.
[18] In 1994, the rent was $9,720. The expenses were interest on the mortgage of $12,061, property taxes of $2,756, and other expenses, for a total of $15,646. Applied against the rent of $9,720, it left a loss of $5,926. For 1995, the gross rent was $10,140, which is within $60 of being the full rent of $850 per month for 12 months. The expenses were the mortgage interest of $11,923, property taxes are $2,922, and other expenses including a substantial roof repair of about $3,200, for a total of $18,864. When that is applied against the rent of $10,140, it produces a loss of $8,724.
[19] The Appellant has pointed out that his losses were declining in each year, and that is correct. Beginning in 1992, the loss was $7,214; in 1993, it was $6,648; in 1994, it was $5,926; and in 1995, it was $8,724. But for the $3,200 roof repair bill, the loss would have been down to $5,524 for 1995, and that would have shown a pattern of declining losses. The profit and loss situation for 1996 is not relevant, although it is disclosed in the Appellant's 1996 return (Exhibit R-5), but it is distorted because the property was sold in 1996. The Appellant showed a terminal loss of about $38,000 on the decline in the value of the property from the time when he took it on as a rental property. That loss has not been challenged by Revenue Canada, but it was not a rental operation for 12 months in 1996, and therefore, 1996 is not an appropriate year to compare with the four preceding years.
[20] From the above losses, I draw two significant conclusions. The first is that the two fixed expenses each year for the property are mortgage interest and property taxes. Secondly, in each year, the total of those two fixed expenses is significantly higher than the gross rent. For 1992, the interest and the property tax total more than $15,300, whereas, the rent is $9,300. In other words, those two expenses exceed the rent by $6,000 and that excess is approximately two-thirds of the rent.
[21] In 1993, it is a similar pattern. The mortgage interest and the property taxes total approximately $15,100 against rent of $9,720. Here, again, the excess of those two expenses alone over the gross rent is more than $5,300, and that excess is significantly more than 50% of the gross rent. The point I am making is that in the two years preceding the years under appeal, the gross rent would have to be increased not just by a small amount but by 50% just to match those expenses of interest and property taxes without the other incidental expenses like insurance and maintenance. For those years (1992 and 1993) the Appellant was allowed to deduct the rental losses reported against his employment income. It is only in 1994 and 1995, when Revenue Canada looked back at a pattern of four years that the losses were disallowed.
[22] I will now review the position for 1994 and 1995. In 1994, the rent was $9,720 and the interest and property taxes amount to $14,800. Again, this is $5,000 more than the rent. And again, the pattern holds that the excess of those two expenses over the rent is more than 50%. In 1995, the amounts are a little better in the Appellant's favour because the rent is up and the expenses are down a bit. The rent is $10,140, and the expenses of interest and property taxes total $14,840, which is $4,700 more than the rent of $10,140. Therefore, for the first time, the excess of those two expenses is a little less than 50% of the rent. However, there were other expenses in 1995 including the roof which brought the total expenses up to $18,864. I would think that the roof, as an extraordinary expense, might have been capitalized. If I eliminate the roof repair cost of $3,200, the expenses would be reduced to $15,664, which is again $5,500 more than the gross rent. So even capitalizing the roof repairs, the other expenses including interest and property taxes, exceeded the rental income by $5,500 which again is more than 50% of the rental income.
[23] The question is whether, when the Appellant embarked upon this rental operation, there was a reasonable expectation of profit. I doubt that there was and I come to this conclusion from two different directions. First of all, there was the fact that the mortgage on the Seaforth Road property was increased by $60,000 or $70,000 in the summer of 1991 when the Appellant had already decided to move out of the dwelling and convert it from being a principal residence for himself and his family to a rental property held for investment purposes. At that time, the interest on the mortgage was 11%. Having decided to make the former Kingston home into an income-producing property, the Appellant had burdened the property with an additional mortgage of $60,000 or $70,000 at 11%. I will give him the benefit of the doubt and assume that the mortgage was increased by only $60,000. At 11% interest, an increased expense of $6,600 is very close to the loss reported in each of the three years.
[24] In other words, but for the increase in the mortgage in the summer of 1991 when the property was being converted from a principal residence to a business investment, the property not only would have had a reasonable expectation of profit but probably would have shown a profit with the reduced interest charge. The new mortgage on the property in 1991 was approximately $115,000 which means that before the $60,000 increase, the mortgage was down to about $55,000. That would make sense because that would then be about one-half of the cost of the property ($112,000) in 1985. The Appellant and his wife obviously had paid down the mortgage in the intervening five or six years after 1985 while they owned it. But as I said earlier, burdening the property with the additional mortgage of $60,000, in my view, was a significant fact in determining whether there could be a reasonable expectation of profit. It almost, if not completely, took away any possibility of producing a profit because they knew at the time that the rental value of the property was only $850 per month, which is $10,200 a year, and yet they were burdening the property with an extra $6,600 in interest expense. That coupled with the property taxes in the range of $3,000 made an immediate charge against the property of $9,600 without considering the interest on the balance of the mortgage (exceeding $60,000) and the other expenses.
[25] I come from a fresh direction now in considering whether in these circumstances, one can be said to have a reasonable expectation of profit. Counsel for the Respondent referred me to the decision of the Federal Court of Appeal in Mohammad v. the Queen, 97 DTC 5503 where Mr. Justice Robertson delivered the unanimous decision of the Court and stated at page 5506:
The above analysis is to the effect that there can be no reasonable expectation of profit so long as no significant payments are made against the principal amount of the indebtedness. This inevitably leads to the question of whether a rental loss can be claimed even though no such payment(s) were made in the taxation years under review. I say yes, but not without qualification. The taxpayer must establish to the satisfaction of the Tax Court that he or she had a realistic plan to reduce the principal amount of the borrowed monies. As every homeowner soon learns, virtually all of the monthly mortgage payment goes toward the payment of interest during the first five years of a 20 to 25 year amortized mortgage loan. It is simply unrealistic to expect the Canadian tax system to subsidize the acquisition of rental properties for indefinite periods. Taxpayers intent on financing the purchase of a rental property to the extent that there can be no profit, notwithstanding full realization of anticipated rental revenue, should not expect favourable tax treatment in the absence of convincing objective evidence of their intention and financial ability to pay down a meaningful portion of the purchase money indebtedness within a few years of the property's acquisition. If, because of the level of financing, a property is unable to generate sufficient profits which can be applied against the outstanding indebtedness, then the taxpayer must look to other sources of income in order to do so. If a taxpayer's other sources of income, e.g., employment income, are insufficient to permit him or her to pay down purchase-money obligations, then the taxpayer may well have to bear the full cost of the rental loss. ...
From that passage, it appears to me that a taxpayer could achieve the deductibility of a rental loss only if the taxpayer demonstrated a pattern of paying down the mortgage indebtedness so as to reduce the burden of high interest charges.
[26] The Appellant stated that he and his wife did accumulate capital but purposely did not pay down the mortgage because, when they negotiated with the mortgage company, which I understand was London Life, it agreed that: "Yes, they could apply accumulated savings to pay down the principal amount of the mortgage but it would not reduce the monthly payments required to be made on the mortgage in accordance with the terms of the mortgage as originally negotiated in 1991". On that basis, the Appellant and his wife decided not to pay down the mortgage. That is a business decision they made because the payment of an additional principal amount was not going to reduce their monthly payments and, therefore, would not help the family cash flow.
[27] If the accumulated savings had been applied to pay down the principal amount of the mortgage, the monthly payments may have remained at the same relatively high level, but a much smaller portion of those monthly payments would have been chargeable as interest and a much higher portion would have been attributed to principal. With a reduction in the amount of interest charged, there might have been enhanced opportunity to show that there was a reasonable expectation of profit.
[28] In the circumstances, without any attempt to pay down the principal amount of the mortgage, the Appellant embarked on this rental operation knowing full-well that with a burden of $12,000 interest over at least a five-year period, plus property taxes in the range of $3,000, there was no reasonable expectation of profit when this rental operation commenced in the summer of 1991. For that reason, I dismiss these appeals for the 1994 and 1995 taxation years.
[29] I would add that the Appellant indicated that the taxation year 1996 was not reassessed by Revenue Canada and it accepted the losses reported and, therefore, 1996 may now be a closed year. I assume that 1996 is not closed for reassessment purposes because the Appellant's return for 1996 would have been filed in the spring of 1997 and assessed sometime after that, and there is a three-year period within which the Appellant can be reassessed. I simply add that, to the extent that bona fide losses were suffered by the Appellant in 1994 and in 1995, not deductible in computing income for the reasons given in this judgment, I should think the amounts of those two losses could be capitalized and added to the cost of the property, thereby possibly increasing the terminal loss for 1996. I am not making a decision to that effect because the year 1996 is not before me but it is my understanding that when a loss in circumstances like this is not deductible, it can be capitalized and added to the cost of the property. I make that observation in case the Appellant can find anything in that worth pursuing with Revenue Canada for 1996. The appeals for 1994 and 1995 are dismissed.
Signed at Ottawa, Canada, this 29th day of July, 1999.
"M.A. Mogan"
J.T.C.C.