Date: 20010727
Docket: 1999-2081-IT-I
BETWEEN:
LONE SMITH,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
For the Appellant: The Appellant herself
Counsel for the Respondent: Jocelyn Espejo Clarke and Scott Simser
___________________________________________________________________
Reasons for Judgment
(Delivered orally from the Bench
at Toronto, Ontario, on September 20, 2000)
Bowie J.
[1] There are two appeals before me that are brought under the informal procedure; one for 1994 and the other for 1995. They concern the Appellant's claim to deduct the losses incurred in connection with a triplex housing unit in those two years from her other income pursuant to section 3 of the Income Tax Act.
[2] The Appellant is a school principal; before that, she was a teacher. In both of those occupations she has had a substantial salary. She started to invest in rental properties in the Toronto area in 1977. First, she bought a house containing three apartments. In 1978, she bought a second house having four apartments. At one point she was renting out a total of 13 apartments. In 1987, she and her husband bought a house in which they have lived ever since.
[3] By the beginning of 1990, the Appellant had sold all of the rental properties, except one at 577 Indian Road. In February 1990, she bought the property at 53 9th Street in Mimico, which is the subject of these appeals. I shall refer to it as "the property". I say that "she" bought it because it was her contention at the hearing of these appeals that she was the sole owner of the property. It is registered in the name of her husband, Larry Smith, however, and one of the assumptions pleaded by the Deputy Attorney General is that Larry Smith bought the house and is the owner of it. Oddly, another of the assumptions pleaded is that the losses incurred in connection with the property were personal or living expenses of the Appellant.
[4] At the outset, there were three matters of contention between the parties in this case:
(i) Whether the Appellant or her husband was the owner and suffered the losses in question;
(ii) Whether the property, or the business of operating it, was in 1994 and 1995 a source of income. The Minister contends that it was not, and he relies on the doctrine of absence of a reasonable expectation of profit as it has been expounded in Moldowan v. The Queen,[1] Tonn v. The Queen,[2] Mohammad v. The Queen[3] and Mastri v. The Queen;[4] and
(iii) The quantum of the losses for the two years under appeal.
[5] In filing her returns for the 1994 and 1995 taxation years, the Appellant claimed to be entitled to deduct losses of $22,541.91 and $26,306.85, respectively. After an adjournment and some discussion, the parties agreed that for those two years the expenses in connection with the property were respectively $41,776 and $40,749. The agreed upon losses are therefore calculated as follows:
|
Gross Rental Income |
Expenses |
Losses |
|
|
1994 |
$22,340 |
$41,776 |
$19,436 |
|
1995 |
$22,891 |
$40,749 |
$17,858 |
There remain the issues whether the property was a source of income, within the meaning of that expression as it is used in section 3 of the Act, and whether the Appellant or her husband is entitled to the loss.
[6] The property was purchased in February 1990 for $363,000 which was made up as follows:
1st mortgage with Royal Trust Company: $271,500
2nd mortgage $ 41,900
3rd mortgage $ 25,000
Total $338,400
Balance in cash: $24,600
The house had three apartments and all of them were rented at the time of purchase. The rent being obtained for the first floor apartment was $900 per month, for the second floor $763.58 per month; and the basement $800 per month, a total of $2,463.58 per month, which amounts to $29,563 per year.
[7] The evidence of the Appellant was somewhat vague as to the precise terms of the various mortgages, including the interest rates. The annual taxes at the time of acquisition were about $4,000 and have increased considerably since that time. By February 1990, the Appellant and her husband had acquired considerable experience in operating apartment buildings of a similar kind, and I am satisfied that they went into this property with not only the intention of making it commercially viable in the short run, but also with a reasonable prospect of doing so. The Appellant had a substantial salary from the school board from which she could reasonably expect to make significant payments on the mortgages. She expected to be able to collect $30,000 per year in rent, and in fact, it was her expectation that these rents could be increased by about 8%. For his part, her husband was able to do much of the work of managing the business aspects of the property and the maintenance and repairs in connection with it. Both the Appellant and her husband, according to the evidence, from time to time did maintenance, renovation and repairs.
[8] Unfortunately, a number of adverse circumstances came together to thwart their plans. The first of these was the economic downturn of 1990, which had the result that tenants became unemployed and were unable to pay the rent, and it was difficult to replace them, leading to vacancies which they had not anticipated and had no particular reason to anticipate. From time to time, there were difficulties in collecting the rent, although the only time when a tenant who was not paying rent was difficult to evict from the property was after the years in question here. All of these things have conspired to limit the gross rental income to something considerably less than had been expected. It fluctuated between a high of $38,435 in 1991, according to the Minister's assumptions (although the Appellant was doubtful about that particular assumption) to a low of $21,350 in 1996.
[9] In addition to the other difficulties, the imposition of statutory rent controls in Ontario prevented any significant rent increase for a period of years, and this, of course, was not something that could necessarily have been foreseen in 1990. In August 1990, soon after the purchase of this property, the Appellant's husband's business failed. This had the result that they had to divert a certain amount of cash to paying debts associated with that, and in order to do so, they were required to sell the triplex at 577 Indian Road in the spring of 1991.
[10] In late 1990, the third mortgage on the property, which was a mortgage taken back by the vendors, went into default. The Appellant was able to obtain funds from a family source to pay off this mortgage, which she did. She also replaced the second mortgage in July 1991, with a first mortgage on the family home in which she and her husband lived. Despite these measures, however, the property has continued to lose money at a rate averaging $18,500 per year up to and including 1999, which is to say, for the first ten years following its acquisition.
[11] This, together with the absence of any definite plan to remedy the situation, it is argued by counsel for the Respondent, establishes that there could have been no reasonable expectation of profit in the years 1994 and 1995. I did not understand him to be taking the position that the acquisition initially was an unreasonable one, but simply that by 1994 the Appellant must have realized that the property, as financed at that time, could not make money and so she should have sold the property at whatever price she could get for it and cut her losses at that point.
[12] I have no doubt that the Appellant went into this purchase with both the intention and the expectation of making a profit. Was that expectation reasonable? I believe, given the climate of late 1989 and the first month or two of 1990, that it was. Certainly, there was no personal use made of this property by the Appellant or any of her family members. Quite the contrary, it has clearly required a great deal of time and effort by her and her husband to operate it over the last decade.
[13] The Appellant testified that she attempted to sell the property in 1991, but that nobody showed the least interest in purchasing it. Counsel for the Respondent takes the position that the Appellant should have attempted to sell it again in 1994. The Appellant testified that she was aware of the market conditions generally throughout this period, and that, in particular, she was aware that values in the location of this property remained depressed at that time. By December 1995, the first mortgage principal had been reduced to $248,600, the second mortgage liability had been transferred from this house to the residence of the Appellant and her husband, and the third mortgage had been paid off. However, from the evidence of sales that was introduced by the Appellant, I infer that the first mortgage balance outstanding alone was substantially more than the market value of the property at that time.
[14] The Appellant and her husband did not have the resources available to them to pay the difference between the reduced value of the house and the outstanding principal on the first mortgage. A sale of the property was, therefore, simply not possible. The Appellant remains convinced that this property will prove to be profitable in the near future, and she has recently been advised that the rents currently charged are below the market rate. She intends to continue to reduce the mortgage principal.
[15] Counsel for the Respondent relies heavily on the decisions of the Federal Court of Appeal in Mohammad and Mastri. This is not, however, a case where it was obvious from the outset that the property could not produce a profit, nor is it a case in which there is any personal element in connection with the acquisition or use of the property. As the Federal Court of Appeal said in Tonn, at paragraph 64, where there is no personal element in evidence, the Moldowan test should be applied sparingly. As it was put in Mastri, at paragraph 12:
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.
Immediately following this passage, the Court referred, with apparent approval, to a number of cases, including Wallace v. The Queen,[5] in which I held that the taxpayer was entitled to deduct the losses suffered in respect of a property acquired as an investment in circumstances very similar to those of the present case. In the Wallace case, in fact, the financing of the acquisition was entirely with borrowed money. The Appellant there, like the Appellant here, was a victim of the recession of the early 1990s. It is easy, with the benefit of hindsight, to say that the purchase in this case was at too high a price and too high a leverage. The fact is that in 1990 it was a reasonable business judgment to make, and it is also a fact that having purchased the property, the Appellant simply was not in a position to sell it by 1994 or by 1995.
[16] I turn now to the question of whose loss is it? The Appellant explained in her evidence that she had the property transferred into her husband's name at the time of acquisition because he had more time than she did to attend at lawyer's offices, to sign papers, and to do all the other running around that was required. She was, she said, working very long hours and simply did not have the time available that her husband had. For the same reason, her husband dealt with the tenants, looked after the paying of bills, and various business aspects of the enterprise. No trust document of any kind was prepared at the time of the acquisition or since then, and the Appellant gave no evidence of any specific oral agreement between them with respect to either the ownership or the operation of the property.
[17] The Appellant testified that she had the high income, and she provided the purchase money, and her husband gave evidence to the same effect. Their evidence in this regard is, of course, self-serving because, at least during the years under appeal and, it would appear, in most years, the Appellant had by far a higher income than her husband and was, in fact, subject to income tax at the highest marginal rate, so that their joint economic interests are best served if the losses are hers.
[18] When the Appellant's husband testified, he made repeated references to the acquisition as being by "we" rather than by his wife, and he continued to use the plural in respect of the operation of the property and their decision-making, even after I had brought this to his attention. When the hearing was resumed, some weeks later, only the Appellant gave evidence, and she avoided the use of the plural pronoun.
[19] Mr. and Mrs. Smith operated a joint account into which the rents from the property were deposited and from which associated bills were paid. As I understood it, their only other bank account was an account of hers into which her paycheque from the school board was deposited and from which she wrote cheques to her husband to deposit in the joint account. In addition to the deposits to the joint account, required for their ordinary living expenses, she transferred money from her sole account to the joint account as required to cover the losses in connection with this property. There was no suggestion in the evidence that she paid Mr. Smith any amount for assisting her with the business aspects of the property, the running around, which she referred to him doing, or any of the maintenance and repair work which he did. The amount of $24,600 cash, which was paid as a down payment, she said came from the sale of another property, which I take it was registered in her name. When it became necessary to raise money to retire the second mortgage of some $40,000 or so, the source of this was a mortgage placed on the family residence.
[20] In the absence of any specific evidence as to an agreement between the Appellant and her husband, and having regard to the pooling of funds in the joint account, the mortgage on the family residence, the proceeds of which went into this property, and the sharing of responsibilities in respect of management and upkeep of the property, and the husband's covenant on the various mortgages given at the time it was acquired, I have reached the conclusion that the operation of this property was in fact a 50/50 partnership between the Appellant and her husband. The Appellant's contribution to the partnership was mostly, but not entirely, a financial one. The husband's contribution was mostly, but not entirely, made up of his labour and management services.
[21] In the result then, I reach the conclusion that in 1994 and 1995, this partnership business did in fact comprise a source of income within the meaning of that expression in section 3 of the Income Tax Act, and that the Appellant is entitled to deduct, in those years, her 50% share of the losses, which amounts to $9,718 in 1994 and $8,929 in 1995.
[22] The appeals will, therefore, be allowed and the reassessments referred back to the Minister of National Revenue for reconsideration and reassessment on that basis.
Signed at Ottawa, Canada, this 27th day of July, 2001.
"E.A. Bowie"
J.T.C.C.
COURT FILE NO.: 1999-2081(IT)G
STYLE OF CAUSE: Lone Smith and Her Majesty the Queen
PLACE OF HEARING: Toronto, Ontario
DATE OF HEARING: July 20 and September 19, 2000
REASONS FOR JUDGMENT BY: The Honourable Judge E.A. Bowie
DATE OF JUDGMENT: September 25, 2000
APPEARANCES:
For the Appellant: The Appellant herself
Counsel for the Respondent: Jocelyn Espejo Clarke and Scott Simser
COUNSEL OF RECORD:
For the Appellant:
Name: The Appellant herself
Firm: N/A
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada