Tax Court of Canada Judgments

Date: 19980205

Dockets: 96-1999-IT-I; 96-2000-IT-I

BETWEEN:

MARVIN SAUNDERS, JUDITH SAUNDERS,

Appellants,

and

HER MAJESTY THE QUEEN,

Respondent,

Reasons for Judgment

Bowman, J.T.C.C.

[1] These appeals were heard together and concern assessments for the 1991, 1992 and 1993 taxation years. The issue is the deductibility of losses sustained by the appellants from the rental of property.

[2] Marvin Saunders is an engineer with INCO Limited, Judith Saunders, his wife, teaches school. Their combined annual incomes in the years in question were over $100,000.

[3] In 1989, they purchased a condominium unit in Kingston, Ontario as an investment. They did so with the intention of holding it as an income producing property. If subjective intention is relevant, as counsel for the appellant contends, I find as a fact that it was their intention to earn income from the property and to hold it as a long term investment. There is no suggestion in the evidence or the pleadings that they acquired it with a view to selling it, or that the prospect of capital gain was a motivating factor in the acquisition.[1]

[4] Moreover, I find as a fact that there was no personal element involved in the acquisition or use of the property. Neither Mr. and Mrs. Saunders nor any of their relatives have ever lived there.

[5] The property was purchased after considerable research. Both appellants were familiar with the Kingston area, having attended university in that city. The building in which they purchased the condominium was, and apparently still is, regarded as one of the most desirable in Kingston. It is situate between a park, a golf course and the lake.

[6] Also, in March of 1989, before the transaction closed they consulted with a tax accountant, Mr. Edward G. Skinner, F.C.A. on the tax implications of the purchase, including the deductibility of interest, the rate of depreciation and the advisability of their locking into a five year mortgage.[2]

[7] The property was listed for rental at $1,300 per month and ultimately leased for $1,250, on July 1, 1989. The property remained rented to that tenant until November 1992.

[8] The rent gradually rose to $1,425 by November 1992. In 1993 and 1994, it was $1,400 per month. In 1995 to April 1, 1996 it was $1,300 and then $1,350 per month.

[9] These rental rates, which were received from arm’s length tenants, represented fair market value.

[10] An important feature of this case is the fact that the purchase price of $240,000 was 100% financed by mortgages on the condominium in Kingston and the appellants’ home in Naughton, Ontario. It is this aspect of the case that I find most troubling. Nothing else makes it any different from any other commercial venture. It was a carefully researched purchase of a desirable rental property in a good location in Kingston. No personal element was involved. The only thing unusual was the 100% financing, at rates which were locked in at 11.75% during the three years in question. The rates fell in 1994 to 8.05% on one mortgage and 7.25% on the other. They have varied since that time between 5.5% and 9.5%. They are arm’s length rates.

[11] By the end of 1993, the appellants had paid down $23,887 on the principal. By the end of 1997, they had paid down $83,446. They projected that by 2004 the entire mortgage will be paid off, on the assumption that interest rates remain at 6% or lower.

[12] Exhibit A-6 sets out the actual profits and losses up to the end of 1994. It also sets out what they would have been, assuming the expenses had remained the same, but that rents had increased by 5%, 7% and 10%. On the most favourable hypothesis there would be no profit until 1997, following which the profits will steadily increase. Exhibit A-5 indicates that based on actual data a profit was realized in 1997.

[13] We have, therefore, two additional factors that must be taken into account:

(a) that in 1989 on the most favourable assumption a profit could not be realized until 1997;

(b) that it was reasonable to expect a profit in 1997 and in fact a profit was realized in that year. It is also reasonable to anticipate increasing profits after 1997.

[14] We have then the following ingredients:

(1) a bona fide intention to earn income from the holding of a rental property;

(2) no personal element;

(3) a reasonable projection of profit after eight years, and, in fact, an actual realization of profit in 1997 and a reasonable expectation of increased profits;

(4) a plan to pay off the mortgages by 2004, a period of 15 years from the date of acquisition;

(5) interest expense that exceeds the gross rents every year until 1997;

(6) 100% financing.

[15] Counsel for the respondent contended that once a profit is realized this project becomes a “source of income” because there is a reasonable expectation of profit but in the years when losses are sustained — and are expected to be sustained — there is no reasonable expectation of profit and therefore, following the obiter dictum in Moldowan v. The Queen, 77 DTC 5213, the losses are not deductible. The argument has a familiar ring. Obviously the question of the deductibility of losses arises only in a year when there is a loss. If the “reasonable expectation of profit” doctrine is to be applied solely because of an anticipated loss in the early years, but the profits earned in the subsequent years are taxable, it would follow that no such losses could ever be deducted. This is not in my view what the “no reasonable expectation of profit” rule means. If it is reasonable to expect profits within a reasonable period of time — and what is reasonable is a question that must be determined in all of the circumstances — the existence of losses in the earlier years does not in itself lead to the conclusion that there is no reasonable expectation of profit in the years when the losses are sustained.

[16] Since the Moldowan case, we have a trilogy of cases in the Federal Court of Appeal that afford considerable guidance in this area. In Tonn et al. v. The Queen, 96 DTC 6001. Mr. Justice Linden, speaking for the court, said at page 6008:

The Moldowan test is stricter that the business purpose tests set out in subsection 9(1) and paragraph 18(1)(a). As mentioned above, these tests stipulate that a taxpayer be subjectively motivated by profit when incurring an expenditure. The Moldowan test, however, also requires the presence of a profit motive, but, in addition, it must be objectively reasonable. In reality, in most situations, the objective Moldowan test and the subjective statutory tests will not yield many different results. A subjective intention is often determined by what may be reasonably inferred from the circumstances. Someone who claims a subjective intention that is foolish may not be believed. A taxpayer’s intention to produce profit normally has to be reasonable before a Court will accept it.

[17] At pages 6009 and 6010 he said:

A closer look at this jurisprudence will illustrate that this is the approach now taken in most of the cases. The cases in which the “reasonable expectation of profit” test is employed can be placed into two groups. One group is comprised of the cases where the impugned activity has a strong personal element. These are the personal benefit and hobby type cases where a taxpayer has invested money into an activity from which that taxpayer derives personal satisfaction or psychological benefit. Such activities have included horse farms, Hawaii and Florida condominium rentals, ski chalet rentals, yacht operations, dog kennel operations, and so forth. Though these activities may in some ways be operated as businesses, the cases have generally found the main goal to be personal. Any desire for profit in such contexts is no more than a “pious wish” or “fanciful dream”. It is only a secondary motive for having set out on the venture. What is really going on here is that the taxpayer is seeking a tax subsidy by deducting the cost of what, in reality, is a personal expenditure.

[18] As stated above, I do not think there is any personal element involved. The ownership and rental of the property is obviously not a hobby. At page 6011 he said:

The other group of cases consists of situations where the taxpayer’s motive for the activity lacks any element of personal benefit, and where the activity cannot be classified as a hobby. The activity, in these cases, seems to be operated in a commercial fashion and not as a veiled form of personal recreation. Usually these deductions are not challenged by the Department, and, therefore, they do not get appealed and are not reported very often in the law reports. The Courts still have a role, however, in deciding whether there exist less apparent factors which might suggest a different conclusion in cases such as these. The Courts are less likely to disallow these expenses, but they do so in appropriate circumstances.

[19] At page 6012 he said:

When the cases are categorized into two groups as above, one cannot help observing that the hobby and personal benefit cases are rarely decided in the taxpayer’s favour. In contrast, where the activity is purely commercial, they rarely are challenged. If they are the Courts have been reluctant to second-guess the taxpayers, with the benefit of the doubt being given to them. I also note that in terms of sheer numbers, the hobby/personal-benefit cases vastly outnumber those of the commercial activity and variety, which are quite rare, indicating that taxpayers are challenged less often in such situations.

The primary use of Moldowan as an objective test, therefore, is the prevention of inappropriate reductions in tax; it is not intended as a vehicle for the wholesale judicial second-guessing of business judgments. A note of caution must be sounded for instances where the test is applied to commercial operations. Errors in business judgment, unless the Act stipulates otherwise, do not prohibit one from claiming deductions for losses arising from those errors. This point was stated strongly by Sheldon Silver.

[20] At page 6013 he said:

Though I do not support the use in the Nichol case of the word “patently”, I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

[21] At page 6014, he referred to the fact that losses may occur for several years until the project becomes profitable. Here the appellants have demonstrated that the project is capable of becoming profitable. I do not think that the eight years is in itself unreasonable, unless one considers that the 100% financing is itself unreasonable. I shall deal with this point when I come to discuss Mohammad v. The Queen, 97 DTC 5503.

[22] At page 6015 he said:

The evidence clearly showed that the taxpayers engaged themselves in a business enterprise and their expectations of profit were not unreasonable in the circumstances. A small rental business was launched without the aid of sophisticated market analysis at a time when the rental market looked promising. Soon after, as a result of unforeseen circumstances, it became precarious. No personal benefit accrued to the taxpayers by the rental arrangements. The property was not a vacation site. The house was not used to give free or subsidized housing to relatives or friends. They made an honest error in judgment and lost money instead of earning it. It is not for the Department (or the Court) to penalize them for this, using the reasonable expectation of the profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.

[23] After the decision in Tonn, the Federal Court of Appeal decided A.G. of Canada v. Mastri et al., 97 DTC 5420. The Federal Court of Appeal stated that there was no doubt that Tonn was correctly decided. The decision of the Tax Court of Canada was reversed on the basis that it was an error in law to say that just because there was no personal element involved an unchallenged finding of fact that there was no reasonable expectation of profit was not sufficient grounds for disallowing the loss. The error of the Tax Court of Canada appears to have been in the interpretation that it put on Tonn that the absence of a personal element superseded the finding of no reasonable expectation of profit. In fact, the finding of the Tax Court of Canada that there was no personal element appears to have been suspect since the taxpayers bought the house to be used as their personal residence and in fact, after one year, they moved into it.

[24] I have no difficulty in reconciling Tonn with Mastri.

[25] In Mohammad it was held to be an error in law to reduce the amount of interest deductible by an arbitrary amount under section 67. In Mohammad there was 100% financing. At page 5506 Robertson J.A. said:

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 twenty to twenty-five 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. Certainly, vague expectations that an infusion of cash was expected from Aunt Beatrice or Uncle Bernie will not satisfy the taxpayer’s burden of proof. In practice, the taxpayer will discharge that burden by showing that significant payments were in fact made against the principal indebtedness in the taxation years closely following the year of purchase.

[26] It is clear from Mohammad that 100% financing is not in itself a justification for disallowing part of the interest provided that the taxpayer can meet the reasonable expectation of profit test.

[27] I find on the facts that the appellants have done so. Obviously, if, as Mohammad has held, 100% financing is no bar to full deductibility of interest, then it may take somewhat longer to pay the mortgage down to the point at which a profit is being realized. If it is arbitrary (and therefore wrong) to reduce the amount of interest deductible because the property was 100% financed, it would be equally arbitrary to pick a number of years (say three or five) in which the appellants must start earning a profit.

[28] Here the appellants started earning a profit in eight years and have a plan to pay off the mortgage within a reasonable period of time.

[29] I find as a fact that the appellants have demonstrated that, contrary to the four bases of disallowance set forth in the assumptions, they had a reasonable expectation of profit, that the expenses in connection with this rental project were laid out for the purpose of gaining or producing income, that they were not personal or living expenses and that they were not unreasonable.

[30] In fact the last point, that the expenses were unreasonable, was abandoned at trial. I might add that the facts in this case are virtually indistinguishable from those in Wallace v. The Queen, [1996] T.C.J. No. 583 (QL).

[31] The appeals are allowed with costs and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.

[32] The appellants are entitled to one set of counsel fees.

Signed at Ottawa, Canada, on this 5th day of February 1998.

"D.G.H. Bowman"

J.T.C.C.

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