Date: 19980424
Docket: 95-3222-IT-G
BETWEEN:
BRIAN J. STEWART,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
McArthur, J.T.C.C.
[1] This appeal concerns assessments for the 1990, 1991 and 1992 taxation years. The issue is the deductibility of losses incurred by the Appellant from four condominium rental properties purchased in 1986. Two of the properties were in London, Ontario and the remaining two were in Surrey, British Columbia.
[2] The Appellant, Brian J. Stewart, is recently retired from senior positions with the Toronto Transport Commission that included property management. His annual income ranged from $65,000 in 1986 to over $90,000 during the years in question.
[3] The Appellant is a highly intelligent, experienced real estate investor. His first rental property was acquired in approximately 1963. A second property was acquired in the late sixties. These properties were later disposed of. At the time the subject properties were purchased, the Appellant owned, either alone or with partners, six other similar rental units in London: he acquired a rental property in 1982, two additional properties in 1986, and a further three properties in 1987. He presently retains three of the four subject units.
[4] The subject properties were purchased after thorough research. Although living in Toronto, the Appellant was very familiar with the London area and informed himself with respect to the Surrey market. He had a daughter living near Surrey and was attracted by the potential of the area. The Appellant carefully studied Reemark's pro forma memorandum with projections of income, profits and losses over a ten-year period. He had an exceptional understanding of the complex details. While his history in real estate reflects a pattern of acquiring properties with a down payment of approximately 25% of the purchase price, he chose to purchase the subject units through almost 100% financing by granting on each unit a first and second mortgage, promissory notes and only $1,000 in cash. This was the first time that he had purchased properties on such a highly leveraged basis.
[5] He acquired two rental condominium apartment units in the project referred to as Meadows of White Oaks Phase II ("White Oaks") situated in London, Ontario, by way of purchase agreements dated December 11, 1986 and similarly acquired two rental condominium apartment units in a project referred to as Park Woods located in Surrey, British Columbia, by way of purchase agreements dated December 18, 1986. Each of these projects was a syndicated real estate development promoted by the Reemark Group. Each of the properties was sold on the basis that the purchaser would be provided with a turn-key operation, that management would be provided, and that a rental pooling agreement would be entered into. The developer arranged financing for the projects.
[6] Each of the White Oaks units is a two-bedroom apartment that cost $72,990. The Appellant paid $1,000 in cash, assumed the first mortgage representing 72% of the purchase price, $52,553, and delivered promissory notes aggregating $19,437, for each unit.
[7] Unit No. 102 in Park Woods is a two-bedroom apartment that cost $74,990. Unit No. 318 Park Woods is a one-bedroom apartment that cost $58,990. He paid $1,000 in cash for each apartment, assumed a first mortgage equal to 75% of the purchase price, being $44,243 for the one bedroom unit, and $56,243 for the two-bedroom unit. He provided a promissory note to the vendor of $14,747 in respect of the one-bedroom unit, and $18,747 in respect of the two-bedroom unit.
[8] The Appellant was provided with projections of rental income and expenses in respect of each of these projects. The original projections contemplated payout of the promissory notes over a period of years terminating in 1994. The projections reflected interest expense associated with the promissory note and first mortgage financing, and an increase in the first mortgage debt in three years to reflect an upward financing. The offering documents also projected negative cash flow and income tax deductions for approximately a ten-year period in all cases. The marginal tax rate reflected in the projections was for a person resident in Ontario having a marginal tax rate of 55.47% in 1986 and 52.53% for 1987 and thereafter. In 1986, Mr. Stewart did not have significant income levels for income tax purposes and little if any of his income for tax purposes was subject to tax at the top marginal rates.
[9] The actual rental experience of the apartment units was worse than projected. The real estate recession of the early 1990's adversely affected rental rates and vacancies. Rental revenues were generally lower and expenses were greater than forecasted. The property management company was changed in about 1991, and the protection of the rental pool was lost as individual owners gradually withdrew their units from the pool. The Appellant suffered rental losses in every year.
[10] Mr. Stewart and his spouse of many years separated in March 1987. He stated that the separation was not anticipated at the time of purchase of the four units. He became burdened by significant financial obligations pursuant to an interim support order obtained by his spouse in May of 1987. Pursuant to a final property settlement agreement executed in 1990, he became obligated to pay the principal interest and taxes on the matrimonial home which he transferred to his wife. The indebtedness was in excess of $100,000.
Position of the Appellant
[11] The Appellant contended that at the time that he purchased the four properties he had the expectation of profit of a reasonable person in his circumstances. Due, however, to the unforeseen circumstances of a divorce from his wife and an economic recession affecting rental vacancies and underlying property values, the expected profit was never realized. Had the rental properties been fully occupied and had he not been faced with divorce obligations totalling over $100,000, a profit would have been realised. He stated that his original intention was to fully pay down the secondary financing by 1990 and that his efforts to pay down the secondary financing, despite the unforeseen problems, evidenced his intention to achieve a positive cash flow as soon as possible. He further contended that the fact that the purchase of the properties was almost 100% financed is not alone determinative of whether he had a reasonable expectation of profit. He also submitted that he is entitled to deduct the carrying charges for monies borrowed to finance the rental losses.
Position of the Respondent
[12] The Respondent argued that the Appellant purchased the properties as a tax shelter, attracted by the promises of (1) income tax deductions and (2) projected capital gains after ten years. Counsel emphasized that the Appellant for the most part simply followed the plan recommended by Reemark. For example, he purchased income guarantees, participated in a rental pool and allowed the interest on the promissory notes to accrue. He argued that the Appellant rejected his own investment rules of thumb for producing positive cash flow from rental properties and instead adopted the Reemark plan that projected ten years of losses. He noted these losses were projected in 1986, at a time when the real estate market was "booming".
[13] Counsel noted the one expense over which the Appellant had control was the interest expense and if he intended to pay down loans he would not have postponed the interest on the notes, which accrued on a compound basis. He conceded the Appellant sold one of the Parkwood units in 1990 and with the proceeds paid down indebtedness on the second Parkwood property, but noted the Appellant's decisions to purchase a personal use condominium in 1988 with $40,000 down and to purchase $66,000 in RRSPs in 1990 contradicted the Appellant's evidence that he did not have the money during the years in question to follow his stated intention to reduce the debt owing on the properties. If his intention was to pay down the principal, argued the Respondent, the Appellant had the opportunity and chose not to take it.
[14] Counsel for the Respondent also proposed that being able to reduce your personal income tax through such mechanisms is a "personal element" in considering the reasonable expectation of profit test.
Analysis
[15] The issue in this matter is whether the Appellant had a source of income from which he could deduct rental losses incurred in the years under appeal. In particular, whether there existed a reasonable expectation to profit from the subject rental properties.
[16] During the course of argument counsel for both parties referred to a number of authorities in support of their respective positions, including the Federal Court of Appeal decisions in Tonn et al v. The Queen, 96 DTC 6001, Mohammad v. The Queen, 97 DTC 5503, and Attorney General of Canada v. Mastri, 97 DTC 5420.
[17] In Mastri, at 5423, Robertson, J.A. (MacGuigan and McDonald, JJ.A. concurring), said the following with regard to the articulation of the reasonable expectation of profit test in Moldowan v. M.N.R., [1978] 1 S.C.R. 480 (S.C.C.):
"First, it was decided in Moldowan that in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, "whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts" (supra at 485-86). If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss."
Having considered whether the Tonn decision purported to alter the law as stated in Moldowan, Robertson, J.A. continued at 5423:
"Tonn simply affirms the common-sense understanding that it is not the place of the courts to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated."
[18] In Mohammad, the issue before the Court of Appeal was whether the Tax Court Judge erred in applying section 67 of the Income Tax Act (the "Act"). In order to provide a background to the Court's analysis of the section 67 issue, Robertson, J.A. (MacGuigan and McDonald, JJ.A. concurring), said the following at 5505-06 with respect to the proper parameters of the reasonable expectation of profit doctrine:
"Frequently, taxpayers acquire a residential property for rental purposes by financing the entire purchase price. Typically, the taxpayer is engaged in unrelated full-time employment. Too frequently, the amount of yearly interest payable on the loan greatly exceeds the rental income that might reasonably have been earned. This is true irrespective of any unanticipated downturn in the rental market or the occurrence of other events impacting negatively on the profitability of the rental venture, e.g., maintenance and non-capital repairs. In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement. The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima facie, to satisfy the reasonable expectation doctrine. These are not cases where the Tax Court is being asked to second-guess the business acumen of a taxpayer whose commercial or investment venture turns out to be less profitable than anticipated. Rather these are cases where, from the outset, taxpayers are aware that they are going to realize a loss and that they will have to rely on other income sources to meet their debt obligations relating to the rental property.
[...]
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."
Both parties to this appeal relied upon portions of this analysis in support of their respective positions. While the analysis is obiter dicta and therefore not binding upon me, I find it instructive and of assistance in determining the outcome of this appeal.
[19] The crux of this appeal is whether the Appellant possessed the intention to pay down the principal, regardless of whether this in fact occurred. Given the evidence, without the intention to reduce the amount of the principal owing on each unit there could be no reasonable expectation of profit. The Appellant's evidence was that his intention was to reduce the amount of the debt at a rate more quickly than that projected in the Reemark plan in order to produce a positive cash flow. The Respondent challenged the credibility of the Appellant's testimony and argued that it was his intention to follow the Reemark plan.
[20] The Reemark plan, which was provided to the Appellant before he purchased the four units, included the pro forma schedule and projections, as discussed above. The effect of the plan was to use rental losses to offset other income and realize a gain at the end of the day from the expected appreciation in the value of the property. The Reemark plan held out no expectation of profit from rental income.
[21] The Appellant was a very experienced real estate investor who in the past applied his "rule of thumb" -- 25% of purchase price down to reduce the risk that the amount of rental income would be exceeded by the interest and other operating expenses, and monthly rents charged on the basis of 1% of the value of the property --- to assure a positive cash flow from properties.
[22] In the instance of the four subject properties, he abandoned his tried and true method. When asked why he had deviated from his normal plan of investment, the Appellant was unable to provide a plausible explanation. The Appellant had an impressive knowledge of his agreements with Reemark and obviously spent a great deal of time analyzing the investment. The Appellant was not an unsophisticated person and clearly understood the projections.
[23] It is true that the Appellant encountered unexpected problems in the form of his marriage breakdown and the economic downturn after the purchase of the subject properties. These factors may explain the inability of the Appellant to pay down the principal outstanding on the properties at a quick enough rate to realize positive cash flows in the years relevant to this appeal. It is also true that the Appellant tried to adopt to the changing circumstances, selling, for example, one of the four subject units and using the proceeds to pay down a portion of the debt on another unit. However, I note that in 1988 the Appellant chose to advance $40,000 in principal toward the purchase of a condominium for his personal use. In 1990, the Appellant received more than $50,000 as a retirement payment, which he sheltered in an RRSP rather than paying down more of the indebtedness. After he finished satisfying his obligations to his ex-spouse in 1992, he made no effort to significantly reduce the amount of the outstanding principal of each unit. The Appellant had several opportunities to reduce the outstanding indebtedness and chose not to.
[24] Having considered all of the evidence, I am not satisfied that the plan that the Appellant followed was realistic in its ability to produce a profit on the subject properties. While the Appellant testified it was his intention to pay down a portion of the outstanding debt, this evidence alone is not enough. As Sarchuk, J.T.C.C. observed in Frank Foldy and Linda Jarian v. M.N.R., 91 DTC 361 at 363 (T.C.C.):
"...The proof necessary to establish the existence of a reasonable expectation of profit from an enterprise goes well beyond the declared intention of a taxpayer, even given under oath. Such a statement, of course, cannot be ignored but all the facts surrounding the acquisition and the operation of the property, its earning potential and its carrying charges, must be such as to satisfy an objective observer that a profit can reasonably be expected to arise from its rental alone (Scott v. M.N.R., 85 DTC 1)."
Here there is a lack of convincing objective evidence of a realistic plan to pay down a sufficient portion of the indebtedness so as to create a positive cash flow. The Appellant has not discharged his burden of showing that the reasonable expectation doctrine was satisfied.
Conclusion
[25] Given the similarity in the circumstances involving each of the four subject properties, I do not think it necessary to analyze each property individually in determining whether there existed a reasonable expectation of profit. I conclude that there was insufficient evidence to find a reasonable expectation of profit with respect to these properties.
[26] The parties argued whether the capital cost allowance ("CCA") should be included in determining whether a reasonable expectation of profit existed. Even if CCA were included in the calculations of the losses, my conclusion that there was no reasonable expectation of profit remains unchanged.
[27] As to the carrying charges, these are not deductible under the provisions of paragraph 20(1)(c) as there is no source of income for which the expenses were incurred.
[28] The appeal is dismissed.
Signed at Ottawa, Canada, this 24th day of April 1998.
"C.H. McArthur"
J.T.C.C.