Date: 19971215
Dockets: 96-4575-IT-I; 96-4676-IT-I; 96-4677-IT-I
BETWEEN:
PHILIP VESCIO, NELLA VESCIO, LUIGI VESCIO,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Sarchuk, J.T.C.C.
[1] These are appeals by Philip Vescio (Philip), his wife, Nella Vescio (Nella), and his brother, Luigi Vescio (Luigi), from assessments of tax made with respect to their 1990, 1991, 1992 and 1993 taxation years. With the consent of all parties, these appeals were heard together.
[2] In computing their income for those years, Philip and Nella claimed rental losses from a property located at R.R. #4, Tottenham, Ontario. In those same taxation years, all three Appellants claimed rental losses from a property at 120 Promenade, Toronto, Ontario. In all instances, the Minister of National Revenue, by his assessments, disallowed the deductions claimed. Since two properties are involved and the participants in each venture are not identical, I propose to deal with the background facts relating to each transaction separately.
R.R. #4, Tottenham, Ontario:
[3] In August 1988, Philip and Nella together with two other individuals purchased the Tottenham property. Each of Philip and Nella acquired a one-sixth interest therein. The purchase price was $250,000, all of which was financed by way of two mortgages for $166,500 and $83,500 each bearing interest at 11¼% per annum. The property consisted of a house located on 15 acres of land and the house itself contained two residential rental units. During the taxation years in issue and the three subsequent years, Philip and Nella reported their share of rental income, expenses and losses as follows:
|
RENTAL INCOME |
1990 14,100.00 |
1991 18,000.00 |
1992 8,100.00 |
1993 16,000.00 |
1994 8,885.00 |
1995 18,900.00 |
1996 18,000.00 |
|
EXPENSES PROPERTY TAXES |
3,043.28 |
2,760.93 |
2,918.89 |
2,506.19 |
3,992.87 |
2,992.72 |
2,156.87 |
|
MAINT. & REPAIRS |
80.04 |
12,656.78 |
514.99 |
6,985.00 |
175.00 |
1,444.00 |
|
|
INTEREST INSURANCE UTILITIES ADVERTISING OTHER TOTAL EXPENSES
NET INCOME (LOSS) PHILIP VESCIO 1/6 |
27,117.52 332.00 303.77 30,876.61 -16,776.61 -2,796.10 |
26,865.04 366.00` 3,131.86 12.84 45,793.45 -27,793.45 -4,632.24 |
28,477.44 373.00 4,329.83 34.78 2,113.90 38,762.83 -30,662.83 -5,110.47 |
17,847.81 429.84 3,790.64 31,559.48 -15,559.48 -2,593.25 |
17,655.98 476.28 3,673.10 179.00 25,977.23 -17,092.23 -2,848.71 |
17,063.51 0.00 3,369.10 23,600.33 -4,700.33 -783.39 |
14,248.83 0.00 2,067.43 19,917.13 -1,917.13 -319.52 |
|
NELLA VESCIO 1/6 |
-2,796.10 |
-4,632.24 |
-5,110.47 |
-2,593.25 |
-2,848.71 |
-783.39 |
-319.52 |
The foregoing schedule reflects the following changes. At the end of 1992, Tottenham was refinanced by way of a first mortgage for $188,000 with interest at 8% and a second mortgage for $52,000 at 7½%. The first mortgage was refinanced in January 1996 for a five-year term, in the amount of $179,246 with interest at 6.45% per annum.[1] The second mortgage appears to have been discharged at some point of time thereafter but the evidence is unclear as to when that was done and as to the source of the funds.
[4] The projected income for this property for taxation year 1997 is $19,200 based on full occupancy. The expenses, primarily as a result of lower mortgage interest, are estimated to be approximately $16,500.
1009 - 120 Promenade, Thornhill, Ontario
[5] Early in 1989, the three Appellants became aware of a condominium project which was under construction. They made an offer to purchase one unit and paid a deposit of $40,000. The transaction closed in December 1990 at the price of $303,000. The balance due was financed by way of mortgages of $122,850 and $45,150 (both at 12¾% per annum) and by borrowing the sum of $95,000 on a line of credit with their bank at 11¼%. Apparently, this loan was secured by way of a mortgage on the personal residence of Nella and Philip.
[6] The property was rented in 1991. The rental income and expense summary for all years up to and including 1996 is as follows:
|
RENTAL INCOME |
1990 0.00 |
1991 11,250.00 |
1992 14,875.00 |
1993 13,775.00 |
1994 17,187.50 |
1995 16,000.00 |
1996 15,140.00 |
|
EXPENSES PROPERTY TAXES |
167.00 |
2,388.50 |
4,762.03 |
3,106.14 |
2,640.12 |
2,221.38 |
2,443.52 |
|
MAINT. & REPAIRS |
4,255.04 |
3,402.36 |
4,028.32 |
4,206.10 |
4,081.82 |
4,741.82 |
3,980.51 |
|
INTEREST INSURANCE UTILITIES ADVERTISING OTHER TOTAL EXPENSES NET INCOME (LOSS) PHILIP VESCIO 1/4 |
1,249.84 417.43 6,089.31 -6,089.31 -1,522.33 |
31,110.42 591.48 245.72 37,738.48 -26,488.48 -6,622.12 |
24,110.90 139.32 2,617.79 35,658.36 -20,783.36 -5,195.84 |
23,931.40 104.52 31,348.16 -17,573.16 -4,393.29 |
23,487.72 177.74 76.70 30,464.10 -13,276.60 -3,319.15 |
22,039.89 418.25 74.34 29,495.68 -13,495.68 -3,373.92 |
18,690.68 25,114.71 -9,974.71 -2,493.68 |
|
NELLA VESCIO 1/4 LUIGI VESCIO 1/2 |
-1,522.33 -3,044.65 |
-6,622.12 -13,244.24 |
-5,195.84 -10,391.68 |
-4,393.29 -8,786.58 |
-3,319.15 -6,638.30 |
-3,373.92 -6,747.84 |
-2,493.68 -4,987.36 |
[7] In February 1992, the first and second mortgages were combined and refinanced in the amount of $172,550 at 9.6% per annum. On December 1, 1992, the bank loan was replaced by a second mortgage in the amount of $97,000 at 7.5% per annum. Nella testified that both mortgages were "paid off as of 1996 and the early part of 1997", however, as I understood her, that did not clear the indebtedness with respect to the Promenade property since there was a balance of $57,600 due to Scotiabank in respect of the amounts borrowed against their personal home.[2]
[8] Nella Vescio was the only witness for the Appellants. She testified that in the early 1980s, she and her husband purchased two rental properties. In 1986, one was sold at what she described as "a high rate of profit". Given their previous success, Nella and Philip decided to invest in Tottenham. Shortly thereafter, they joined with Luigi to purchase the Promenade unit. At the time the decisions were taken to purchase the properties in issue, all three were aware that the real estate market was very active. Their objective was long-term investment with the rental income to carry the property to an ultimate realization of further profit on resale. According to Nella, before proceeding they made their own expense calculations which she believes were written down but were not retained. Based on these calculations and their estimate of rental incomes, the Appellants expected that they would be sufficient to carry the property for the necessary period of time.
[9] Nella further testified that their failure to meet the "projections" was the result of unforeseeable circumstances. First, with respect to Tottenham, they incurred unexpected major one-time expenses of $12,000 for a new well in 1991 and $7,000 in 1993 for repairs to a deck. These amounts, she said, "would have been" applied to reduce the principal amount of the first mortgage. In 1992, a shortfall of some $10,000 in rental income occurred because the tenants were "transient or short while". In 1994, a court order was required to evict a tenant. Major repairs to the unit were needed and rental was not possible until they were completed. As a result, in that year the rental income shortfall was again approximately $10,000. She testified that this lost income would also have been applied to reduce the principal amounts in each of 1992 and 1994 and in result, would have reduced interest costs in those and subsequent years.
[10] To support this proposition and to demonstrate the effect of these one-time expenses and rental income shortfalls, Nella referred to "rental income summaries" made by their representative. His calculations in the Tottenham summary[3] were made on the assumption that in 1991 and 1993, expenses in the amounts of $12,000 and $7,000 had not been incurred and that those amounts had instead been applied to a reduction of principal. He also assumed that the rental income shortfalls of $10,000 in each of 1992 and 1994 had not occurred and that such rental income had also been applied to a reduction of principal. Proceeding on the further assumption that the principal had thereby reduced, he then made "mortgage interest adjustments" for each of those years in the amounts of $3,590.86, $5,830.72, $7,342.40 and $9,075.00. The total of the "amounts paid in reduction of principal" and the "mortgage interest adjustments" was then deducted from the actual net loss in each taxation year to produce an "adjusted rental loss". Similar calculations were performed with respect to Promenade.[4] According to Nella, the cumulative effect of these adjustments establishes that in taxation year 1994, Tottenham would have earned a net profit of $1,982.77 rather than producing a loss of $17,092.23. Promenade for its part, would have shown a profit of $724.78 rather than a loss of $13,495.68 in taxation year 1995.
[11] According to Nella, the Appellants also intended to pay down the principal amounts of the mortgages. However, she was somewhat imprecise as to how or when that was to be accomplished. With respect to Tottenham, because two other individuals were co-owners, the plan appears to have been to make additional payments at the point the mortgages were "coming due" and were to be renewed. Although less clear, a similar "plan" appears to have been contemplated for Promenade. No such payments were made because in 1993, "all of the parties involved ... lost their jobs. ... so our plan had to be delayed for a while ... ". Nella testified that the only method actually used to "pay down" the mortgage:
" ... was that when we renewed the mortgages at the specific dates and times relevant to those mortgages, the amortization period was the -- the amortization periods of those renewed mortgages were renewed at the lower amortization rate as opposed to -- for example, if it was a 25-year amortization originally, and it was down to 21-year amortization, we renewed it at the 21-year amortization, thereby making our payments remain the same, only allowing more towards principal."
One further factor which prevented them from meeting their projections was the effect of the recession on the construction industry and in particular, on the rental market, in that their anticipated rentals did not materialize.
Conclusion
[12] At issue in these appeals is the right of these Appellants to deduct for tax purposes their proportionate share of rental losses from other income pursuant to the provisions of the Income Tax Act (the Act). Paragraph 18(1)(a) of the Act provides:
18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;
...
(h) personal or living expenses of the taxpayer, other than travelling expenses incurred by the taxpayer while away from home in the course of carrying on his business;
[13] In order to succeed the Appellants must demonstrate that the expenditures in issue were made for the purpose of gaining or producing income from business or property. From this flows the requirement that the Appellants must in fact be carrying on a business within the meaning of the Act.
[14] An argument was advanced in this appeal to the effect that the judgment in Tonn et al v. M.N.R.,[5] stood for the proposition that the reasonable expectation of profit is no longer relevant or applicable to the question of deductibility of losses unless the circumstances include an inappropriate deduction of tax, the presence of a strong personal element or suspicious circumstances. In The Attorney General of Canada v. Mastri et ux,[6] Robertson J.A. dealt with such a submission as follows:
... In any event, it is helpful at this point to set out the specific findings of law articulated in Moldowan.
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. There is no doubt that, post-Moldowan, this Court has followed and applied that decision: see Landry v. Canada, 94 DTC 6624; Poetker v. Canada, 95 DTC 5614; and Hugill v. Canada, 95 DTC 5311. The only remaining issue is whether Tonn departs from that jurisprudence by postulating that the reasonable expectation of profit test remains irrelevant to the question of deductibility of losses until such time as it can be established that the case involves an inappropriate deduction of tax, the presence of a strong personal element or suspicious circumstances. ...
After referring to certain passages in Tonn (supra), Robertson J.A. continued:
In my respectful view, neither of the above passages support the legal proposition espoused by both the Minister and the taxpayers. It is simply unreasonable to posit that the Court intended to establish a rule of law to the effect that, even though there was no reasonable expectation of profit, losses are deductible from other income sources unless, for example, the income earning activity involved a personal element. The reference to the Moldowan test being applied "sparingly" is not intended as a rule of law, but as a common-sense guideline for the judges of the Tax Court. In other words, the term "sparingly" was meant to convey the understanding that in cases, for example, where there is no personal element the judge should apply the reasonable expectation of profit test less assiduously than he or she might do if such a factor were present. It is in this sense that the Court in Tonn cautioned against "second-guessing" the business decisions of taxpayers. Lest there be any doubt on this point, one need go no further than the analysis pursued by the Court in Tonn.
[15] With these considerations in mind, I turn to the question - did these Appellants have a reasonable expectation of profit from their undertakings in the taxation years in issue? In the present appeals no personal element is in issue. In Moldowan v. The Queen,[7] Dickson J. (as he then was) observed that:
There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive.
It is understood that in each case, the factors will differ depending on the nature and extend of the undertaking. The proof necessary to establish the existence of a reasonable expectation of profit from an undertaking goes well beyond the declared intentions of a taxpayer, even given under oath. Such statements, of course, cannot be ignored, but all of the facts surrounding the acquisition and the operation of the property, its earning potential, the carrying charges, the previous earning history and so forth must be such as to satisfy an objective observer that a profit can reasonably be expected to flow from the venture.
[16] The facts before me preclude a finding that the Appellants had a reasonable expectation of profit. First, it must be noted that they acquired no equity whatsoever in Tottenham and very little in Promenade, borrowing approximately $515,000 of a total purchase price of $553,000. If expense "calculations" were made with respect to these properties as alleged, the high mortgage interest rates were a known factor and would have been taken into account. It follows that the Appellants must have been aware that the properties, as financed, could not in the reasonably foreseeable future begin to carry themselves. Nonetheless, the Appellants were quite prepared to go ahead with the purchases and to burden themselves with the then current mortgage interest rates ranging from 11¼% to 12¾%. There is no evidence that they could reasonably have anticipated any interest rate reductions in the near future nor is there any evidence that they sought advice or themselves performed any analysis of interest rate trends.
[17] The expense "calculations" made, such as they were, appear to be at the very least, overly optimistic based as they were on full occupancy, "market rental rates" (the source of which information is unknown) and perfect tenants. These projections were simply unrealistic. There appears to have been no consideration of expenses vis à vis matters such as damage caused by tenants or the cost of renovation and up-grading an older building. There was no evidence that rental vacancy rates were considered.
[18] Last, the representative's "rental loss adjustments" relied upon to support the Appellants' position vis à vis potential profitability are arithmetically inaccurate and rely on assumptions which are not supported by the evidence. As to the first point, I refer to the Tottenham summary.[8] On pages 2 and 3, the representative included the schedule of the actual payments made on the first mortgage from October 10, 1988 to October 10, 1992. On the following two pages, he "adjusted" this schedule by incorporating into the calculations the amounts which the Appellants "would have applied to a reduction of principal" if, using 1991 as an example, additional repair expenses of $12,000 had not been incurred. The first such adjustment is made on January 1, 1990 in the amount of $15,000. However, there were no one-time expenses incurred in that year nor for that matter, was there any rental income shortfall. No evidence was presented as to the basis or reason for this adjustment. The second such entry is made as of January 1, 1991, again in the amount of $15,000. Although this number is close to the amount calculated by the representative as the "rental loss adjustment" for that year, such an adjustment cannot properly be made as of January 1 since the repair expenses which form the basis for it were not incurred until much later in that year. Similar adjustments were made on the first of 1992 in the amount of $16,000 and on the first of 1993, 1994, 1995 and 1996 in the amount off $15,000 each. These amounts appear to have no relationship whatsoever to any rental shortfalls or additional one-time expenses incurred and quite obviously, skew the representative's conclusion that had certain payments been made, a profit would have been shown by taxation year 1994 for Tottenham and by taxation year 1995 for Promenade. To put it bluntly, the material prepared by the representative is flawed and does not support the Appellants' contention that barring the unforeseen expenses and rental shortfalls, both properties would have shown a profit in 1994 and 1995.
[19] In Zahid Mohammad v. Her Majesty the Queen,[9]Robertson J.A. observed 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 moneys. As every homeowner soon learns, virtually all of the monthly mortgage payments goes towards the payment of interest during the first five years of a 20 to 25 amortized mortgage loan. It is simply unrealistic to expect the Canadian tax system to subsidize the acquisition of rental properties for indefinite periods.
(Emphasis added)
The evidence before me does not demonstrate that a realistic plan existed. The witness, Nella, spoke of paying down the principal at the point of time the mortgages were up for renewal, but her testimony was short on specifics. With respect to Tottenham, the indebtedness was created in August 1988 when the purchase was completed. Both mortgages on Tottenham were refinanced on December 31, 1992. The evidence indicates that in the four plus years the principal amount had been reduced marginally and that no prepayments were made at any time. With respect to Promenade, the initial financing in 1990 was by way of two mortgages in the amount of $168,000 and a bank loan for $95,000. On March 1, 1992, the two mortgages were combined and refinanced in the amount of $172,550, an increase in the indebtedness. In December 1992, the loan at the bank became a mortgage for $97,000, again an increase in the amount of the indebtedness. The opportunity existed in the case of each property to prepay the principal amounts if that indeed was the Appellants' plan. It was not acted upon.
[20] In my view, these facts fly in the face of the Appellants' assertions that at all times they intended to make such prepayments. Second, the loss of their employment cannot be said to have frustrated their plans to do so since they were employed at least until the mid-summer of 1993. Third, the Appellants maintained that the principal amounts of the indebtedness would be paid down in a number of ways, including other sources. However, there is no evidence with regard to the existence of such a source and, based on their income tax returns which the witness, Nella, reviewed, it does not appear likely that their employment incomes could have been the source. I also observe that with respect to Tottenham, the other two owners did not testify and thus, their financial ability to pay down the mortgages by any substantial amount is unknown.
[21] In so concluding, I am aware of the fact that at the end of 1996 and the beginning of 1997, mortgages totalling almost $400,000 were paid off. There was no evidence before this Court as to the source of these funds, nor was it suggested at any time that such source was known in 1988 and entered into their considerations at the time the decisions were taken to purchase the properties.
[22] The following comment by Robertson J.A. in Mohammad, supra could have been directed to the facts before this Court:
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 whole 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.
[23] The appeals are dismissed.
Signed at Ottawa, Canada, this 15th day of December, 1997.
"A.A. Sarchuk"
J.T.C.C.