Date: 20010501
Docket: 2000-4279-IT-I
BETWEEN:
JOHN L. DESROCHES,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Miller, J.T.C.C.
[1] This is an appeal pursuant to the Informal Procedure by John Desroches of the Minister's reassessments for the 1996, 1997 and 1998 taxation years. In those reassessments of September 9, 1999, confirmed by Notice of Confirmation of July 20, 2000, the Minister disallowed the deduction of rental losses claimed by the Appellant for 1995, 1996 and 1997 in the amounts of $3,075.98, $2,362.43 and $520.12.
ISSUES:
[2] The Respondent, in the Reply to the Notice of Appeal, set forth the issues as follows:
a) whether the Appellant had a reasonable expectation of profit from the rental of the Property 1996, 1997 and 1998 taxation years;
b) whether the expenses disallowed by the Minister in respect of the Property were incurred by the Appellant for the purpose of gaining or producing income from a business or property; and
c) in the alternative, whether the disallowed expenses were reasonable in the circumstances.
[3] The Respondent goes firstly to the reasonable expectation of profit ("REOP") test as being the premier issue - the Moldowan[1] test. Next he turns to section 18(1)(a) of the Income Tax Act ("Act") asking whether the expenses disallowed were incurred for the purpose of gaining or producing income. Finally, he falls back on section 67 of the Act - the reasonableness test. In reassessing the Appellant the Minister disallowed rental losses to be claimed against other income. This, I suggest can be viewed either as allowing the Appellant's expenses up to the amount of the rental revenue (but no more), or disallowing all of the Appellant's expenses, while, at the same time, recognizing none of the rental revenue as a source of income. By framing the issues as he has (referring to disallowance of expenses), I was led to an initial conclusion he was disallowing only those expenses in excess of the rental revenue, implying he was allowing the deduction of expenses up to the amount of the rental revenue. Counsel for the Respondent disabused me of that notion.
FACTS:
[4] The Appellant purchased 4 Chilcot Avenue, Toronto for $165,000 in 1992 as his principal residence. He acquired a mortgage at the time. In 1995 he separated from his wife and, as he described, in order to afford to keep his home he determined to acquire tenants. He advertised by putting up a notice at his place of work. A co-worker responded and moved in until the end of 1997, at which point the Appellant's brother became a tenant and remained so for all of 1998. The tenant's space consisted of the basement area, being a living room, bedroom and bar with a utility room. This space represented approximately 30 percent of the total liveable space in the house. The Appellant indicated the tenant also had the use of the kitchen and bathroom upstairs. The rent charged was less than fair market value as the Appellant was anxious to rent as quickly as possible as he needed the funds. Both the co-worker, and subsequently the brother needed a place due to their own marital difficulties. The following is a summary of the revenue and expenses for the years in question:
|
1996 |
1997 |
1998 |
|
|
Revenue |
$4,800 |
$4,800 |
$4,800 |
|
Expenses (all at 50%) |
|||
|
Insurance |
190.50 |
218.50 |
174.84 |
|
Interest |
4,968.09 |
4,580.03 |
2,801.42 |
|
Maintenance |
475.00 |
250.00 |
200.00 |
|
Property taxes |
995.45 |
1,015.95 |
1,026.66 |
|
Utilities |
1,246.94 |
1,097.95 |
1,117.20 |
|
7,875.98 |
7,162.43 |
(5,320.12) |
|
|
Loss |
(3,015.98) |
(2,362.43) |
(520.12) |
The losses in 1994 and 1995 were $3,531 and $2,960 respectively.
[5] The Appellant kept no receipts for any of his maintenance costs. There was no written lease between the parties, as it was an informal arrangement according to the Appellant. Once the Appellant got his "head above water" he ceased the rental arrangement. This occurred in late 1999 or early 2000.
APPELLANT'S POSITION:
[6] The Appellant's position is that the expenses incurred resulting in the losses claimed were legitimate, reasonable expenses permitted pursuant to section 18(1)(a) of the Act. Representing himself and not having had the scholarship of the plethora of case law on this subject, this is an earnest and appropriate understanding of our tax laws. He had a property; he received income from it; he incurred expenses on it; half of these expenses he claimed were not personal but were incurred to earn that income; this resulted in a loss which he claimed.
RESPONDENT'S POSITION:
[7] The Respondent's position is that:
1. The Appellant did not have a reasonable expectation of profit and consequently, relying on Moldowan, no source of income. He suggested this does not subject the rental revenue and expenses to the purview of the Act.
The next three positions appear to presume the rent is subject to the Act but the expenses over and above the rental revenue are not deductible.
2. The rental expenses which constitute the losses were not incurred for the purpose of producing income within the meaning of section 18(1)(a).
3. The rental expenses which constitute the losses were personal or living expenses (section 18(1)(h)).
4. The rental expenses which constitute the losses are not deductible against other income as they are unreasonable (section 67).
Finally, the Respondent presents an argument in the alternative. In the event I find the Appellant had a rental operation, by which I presume he means "business", as clearly the Appellant received rent, the rental expenses allowed should be prorated to 30 percent of the total expenses. A mathematical calculation on this basis would result in the Appellant having a small taxable income in 1998. The Respondent suggested that if I find this constituted a business it is not the intention of the Minister to tax the Appellant on this small amount, but rather I should simply dismiss the appeal. This alternative argument I find intriguing as it suggests to me that only if I find there is a rental operation or business do I need to consider the deductibility of actual expenses at all. It follows that it is indeed open to interpret the Minister's reassessment on the basis that the losses, being a calculation of both revenue and expenses are not subject to the Act. The Respondent's counsel in fact confirmed this approach.
ANALYSIS:
[8] The Respondent's argument appears to take three forms. First, there is no reasonable expectation of profit, therefore no source of income, therefore the appeal should be dismissed. Second, there is no reasonable expectation of profit, but the disallowed expenses (i.e. the losses) were not incurred for the purpose of producing income but were personal or living expenses and also unreasonable so should not be allowed. Third, if there was a reasonable expectation of profit the expenses should be limited to 30% of the total expenses.
[9] With respect to the first argument, I look to Moldowan as referred to in Mastri v. Her Majesty the Queen, 97 DTC 5420, as follows:
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.
[10] If instead of referring to a source of income, reference is made to a source of profits, it becomes more readily apparent how we can accept the tenet that without a reasonable expectation of profit there is no source of income. If there is no source of income we need not concern ourselves with sections 18(1)(a) and (h) or section 67. We have taken the "rental arrangement" outside the basic inclusionary section of the Act, section 3. To find otherwise in a situation where there is no REOP, that is to find the Minister's assessment is tantamount to a finding that expenses are allowed up to the amount of rental revenue, is faulty logic. I limit this analysis to income from property as different considerations come to play in a situation of income from business. This was in fact alluded to in Mastri, at page 5422:
For the sake of doctrinal purity, I should also point out that a distinction must be drawn between the determination of whether a taxpayer's source of income is from a business as opposed to a property. I may own a rental property but whether I carry on a business in regard thereto is a distinct legal issue giving rise to other tax consequences not relevant to the cases under review. Thus, strictly speaking it is inappropriate to speak of business expenses incurred in relation to a rental property unless, of course, the taxpayer's endeavours are regarded in law as a business. In any event, it is helpful at this point to set out the specific findings of law articulated in Moldowan.
[11] The Federal Court of Appeal did not carry on with this line of distinguishing between business and property for purposes of the REOP test. The Court did go on to explain Moldowan as I have already set out above. The distinction might well be however that income from property has a lower threshold for determining if it constitutes a source of income. That threshold may be an application of the REOP test; whereas to find income from business one only applies the REOP test in light of the definition of business as set forth in the Act and as cautioned by the recent cases of Tonn and Mastri.
[12] So, I will deal with the REOP test. I find the Appellant did not have a reasonable expectation of profit for the following reasons. From 1994 to 1998 there were continual losses. Upon any objective assessment of potential revenue versus expense, it is difficult to see how he could have generated a profit. As the Appellant acknowledged, to keep the house he needed to generate some income quickly, and therefore rented at less than fair market value. If he wanted to keep the house he had to defray the costs of his personal residence. Clearly there is a strong personal element. There was no formal plan or projection provided. There was no written agreement; there was simply, as Mr. Desroches put it, an informal arrangement. Once his needs were met and he attained some financial security there would be no further need to have a tenant, which is the position he is now in. There was no rental operation or business as such, but an informal arrangement with a co-worker and a brother. There was no reasonable expectation of profit.
[13] To be clear this is not a finding of expenses being allowed up to the amount of revenue but a finding there is no source of income subject to the Act. Had the Appellant only claimed 30 percent of his expenses he would have had a small profit in 1998. I do not find this is sufficient to categorize the undertaking as having had a reasonable expectation of profit such as to constitute it a business and a source of income within the meaning of Moldowan.
[14] With respect to the second argument, if I am correct in my analysis it is unnecessary to answer questions 2, 3 and 4 of the Respondent's position. However, if there is what I will call a mid-position (a finding of no REOP but a requirement to still analyze the nature of the denied losses), then I find the expenses over and above the rental revenue were personal or living expenses within the meaning of section 18(1)(h).
[15] Having found there was no reasonable expectation of profit I need not address the Respondent's third argument limiting expenses to 30 percent.
SUMMARY:
[16] It appears there are three routes to follow in an analysis of a case of the deductibility of rental losses against other income where there is a personal element involved:
1. Determine there was no reasonable expectation of profit and therefore no source of income to get past section 3 of the Act. The expenses to consider in this approach are not the actual expenses claimed but an objective assessment of what expenses would be reasonable in the circumstances. Assess the reasonable expectation of profit on that basis.
2. Determine there was a reasonable expectation of profit. In this approach one would then review the actual expenses and determine their legitimacy for deduction considering sections 9(1), 9(2), 18(1)(a) and (h) and 67. The result may well be a loss available for deduction against other income. (see Narine v. Her Majesty the Queen, [1995] 2 C.T.C. 2055)
3. Find there is no reasonable expectation of profit and allow the deduction of expenses only up to the amount of the rental income. This mid-position requires some analysis of the disallowed expenses (the losses) to determine if they can be denied on the basis of section 18 or section 67. While I find such an approach not as conceptually appealing, it appears to have served as a useful practical guide to provide certainty and fairness in similar cases. Applying either the first or third approach yields the same result in the situation at hand and logically always will in the case of rental losses. It may though provide a different result in the event of an unexpected profit. It could also have some ramification as to how a taxpayer files a return; under the first approach the return would show no rental revenue or expense, while following the third approach the return would provide both.
[17] I find no reasonable expectation of profit in this case for the reasons mentioned above and dismiss the appeal. I do so on the basis of the first approach; that is, the rental arrangement does not constitute a source of income within the meaning of the provisions of the Act.
[18] The appeal is dismissed.
Signed at Ottawa, Canada this 1st day of May, 2001.
"Campbell J. Miller"
J.T.C.C.