Date: 20011010
Dockets: 2001-1284-IT-I
2001-1285-IT-I
BETWEEN:
CATHY GILL,
GARY GILL,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
Counsel for the Appellant: John David Buote
Counsel for the Respondent: James Gorham
Reasonsfor Judgment
(delivered orally from the Bench on September 21, 2001 at Toronto, Ontario)
Campbell, J.
[1] These appeals were heard together on common evidence. The Appellants are husband and wife and both gave evidence at the hearing.
[2] At the commencement of the hearing, the parties submitted a statement of agreed facts which read as follows:
Allocation of the Property Value to Land and Buildings
1. In 1991, at the time of the conversion from the principal residence to rental use in 1991, the fair market value of the land was $200,000 and the fair market value of the buildings was $175,000. Accordingly, the opening UCC of the rental buildings in 1991 was $175,000.
2. In 1994, at the time of the 1994 appraisal of the Property, the fair market value of the land was $125,000 and the fair market value of the rental buildings was $125,000.
3. In 1996, at the commencement of the 1996 taxation year, the fair market value of the land was $107,500 and the fair market value of the rental buildings was $107,500.
4. In 1997, at the time of the sale of the Property for $230,000, the fair market value of the land was $115,000 and the fair market value of the rental buildings was $115,000.
5. In 1997, at the time of the sale of the Property, the UCC of the rental buildings was $175,000.
Terminal Loss
6. If there was a terminal loss in 1997, the amount of the terminal loss was $60,000, one-half of which is allocable to each appellant.
[3] The Appellants purchased a property known as the Beamsville property in 1986 and used the property as their personal residence until 1991. The property was at least 95% financed, according to the evidence of Cathy Gill. Several years after 1986, refinancing occurred to complete renovations with the idea that the property would be used as a rental property.
[4] By the fall of 1991 the renovations were completed. An appraisal report by Niagara Credit Union listed the value estimate of the property at $375,000.00. Financing was in place with that credit union for approximately $128,000.00, together with financing with Equitable Trust for approximately $143,000.00.
[5] This property was converted from an entirely personal use residence to a rental property in the late summer of 1991, when the Appellants ceased to reside in that property and moved to a second property which they owned. $1,800.00 income from rental was realized in November and December of 1991. Money on the original mortgages appeared to flow through to the Appellants after completion of renovations with the Appellant, Cathy Gill, explaining that to her recollection bridge financing was used.
[6] Both the Niagara and Equitable mortgages were paid out and one blanket mortgage taken out with CIBC in 1994 against this property and the second property owned by the Appellants.
[7] The Beamsville property consisted of a house and a barn. The evidence of the Appellants was that there was never any personal use of the house or barn after it was rented in 1991.
[8] The evidence disclosed that Gary Gill's primary involvement with the rental was completion of the renovations. Otherwise it was Cathy Gill who looked after the Beamsville property. She testified that prior to 1991 she followed market trends in interest rates and fair market values and had previously owned another property which had significantly increased in value between 1982 and 1991 by approximately $100,000.00. She also discussed opportunities in rentals with lawyers, brokers, accountants and individuals who owned property. She obtained information that the greater the property value, the greater likelihood she would be able to rent to a professional, thus obtaining a greater rental income. Although the property was appraised in 1991 at $375,000.00, she stated that she did not think of selling at that time as she had projected a rental profit in four to five years from renting and she thought she would then be able to sell the property for an even greater sum. Her initial projections were "scribbles on the front of a file folder" and according to her evidence, was based on discussions with numerous people in the know over a number of years. These projections were calculated using a monthly rental figure of $1,600.00 plus utilities with a 4% anticipated annual increase. The projections anticipated that the expected rental revenues would increase from $19,200.00 in 1991 to $22,461.00 in 1995 provided the interest rate would remain at 9% or less. According to these projections, the property would be in a break-even cash flow position by 1995.
[9] Correspondence by a realtor familiar with this property and the area was introduced as part of Exhibit A-1 to support the Appellants' expected monthly rent at that time in that market. The actual projections introduced as an exhibit were reproduced by Cathy Gill as recently as 2001 but she testified that these projections were based on the actual "scribbles she had on her file folder" in 1991. She stated that these projections contained no reference to increases in property taxes through to the year 1995 as she had checked with the local municipality which informed her no tax increases were expected. As well, no amount was included in these projections for maintenance and repairs as the property had been newly renovated and the Appellant, Gary Gill, would most likely be able to complete these if they were required.
[10] The Appellants, however, did not anticipate the duration and severity of the recession of the 1990s. The property was advertised in both the Hamilton and Toronto papers at a monthly rental of $1,600.00. Cathy Gill was also in discussions with the realtor to find a tenant. She was eventually offered $900.00 monthly rent. Rather than leave the property vacant, she did rent it for $900.00 per month but rented on a month-to-month basis only, with 60 days notice to vacate in the event she was able to find a tenant who would pay $1,600.00 monthly or at least more than $900.00 monthly. She stated that after she rented the property, she continued to take out rental ads in the papers. In a further effort to mitigate her losses, she continued to take short term financing against the property so she could obtain the lower interest rates. When she approached the tenant paying $900.00 monthly about an increase, he threatened to move out. Other than continuing to advertise the property for rent and take out short term mortgages to obtain the lowest interest rates, the Appellant was unable to reduce the outstanding principal as she stated she was personally using money out of her own pocket to keep the property going. By September 1994, the value of the property had dropped from $375,000.00 to $250,000.00 according to the appraisal report of Niagara Credit Union. And again the value decreased by December 1995 to between $210,000.00 and $215,000.00 according to a realtor's opinion letter of September 2001. With property values for this type of home declining, the Appellants listed the property for sale and sold it in 1997 for $230,000.00, as they "could no longer afford to hold on to it". The Appellants' evidence was that the property would be worth approximately $280,000.00 in today's market.
[11] The main issue here is whether the Appellants are entitled to deduct rental losses on the Beamsville property in 1996 and 1997 in computing their income for income tax purposes. Did the Appellants have a reasonable expectation of profit from the rental of this property in those years? To succeed here the Appellants must establish on a balance of probabilities that the rental property was held for the purpose of producing income. And finally whether the Appellants can deduct a terminal loss on the sale of the rental property in the agreed upon total amount of $60,000.00.
[12] Both counsel referred me to the various case law in this area beginning with the Supreme Court decision of Moldowan v. The Queen, [1978] 1 S.C.R. 480; 77 DTC 5213 (S.C.C.). The principles which have emerged from the many cases were clearly and concisely summarized by Associate Chief Judge Bowman in the recent decision of Donyina v. The Queen, [2001] T.C.J. 456. Reproduced from paragraph 9 of Judge Bowman's decision, they are as follows:
[9] I shall not quote from these cases or analyse them at length. It is, I think, sufficient to summarize some of the principles that they appear to establish.
1. Where there is no personal element the REOP test should be applied sparingly (Tonn, Keeping, Bélec and Walls). The absence of a personal element does not establish conclusively that the REOP principle cannot be invoked but such an absence is a factor that carries a great deal of weight (Mastri).
2. The Minister or the court should not, with the benefit of hindsight, second-guess the business acumen of a taxpayer who embarks upon a business venture in good faith (Keeping, Tonn, Nichol, Kuhlmann, Bélec and Smith).
3. The fact that a business or property is 100% financed is not in itself a reason for applying the REOP principle (Milewski, Mohammad and Saunders).
4. A taxpayer should be allowed a reasonable period of time to get the business established (Keeping). Such a period will vary with the circumstances and may well be lengthy (Milewski).
5. The REOP principle should not be invoked as a substitute for analysis. Before invoking REOP the assessor should examine the expenses to determine whether they are reasonable or for any other reason not deductible (Smith, Costello and Cipollone).
6. For an expectation of profit to be reasonable it has to be not "irrational, absurd and ridiculous" (Kuhlmann).
7. The fact that an investment or a business is motivated in part by tax considerations is not relevant in determining whether there is a business, nor is tax motivation in itself relevant in determining the deductibility of expenses if a business exists (Stubart Investments Limited v. The Queen, 84 DTC 6305) unless of course the Minister chooses to invoke the general anti-avoidance rule in section 245, in which case we are into a fundamentally different ball-game.
8. The initial question where losses are claimed and denied is whether they are personal or living expenses, the statutory definition of which includes the REOP test. If they are not, the REOP test must be applied with extreme care and the question becomes "Is there a business?" The existence of REOP is only one factor in that determination (Kaye).
9. Reasonableness operates both in the context of the existence of a business, where section 67 disallows the deduction of expenses to the extent that they are unreasonable, and also at the liminal stage of determining whether there is a business (Kaye).
10. If what is ostensibly a rental property was acquired and held in the course of an adventure in the nature of trade and it was reasonable to expect a profit on the resale the losses (i.e. carrying costs net of rentals received) should not be disallowed on the basis of REOP (Roopchan). The court should however examine with some care an ex post facto declaration that property that was carried for some years at a loss is part of a speculative venture in which the motive was resale at a profit. This is not something that one would expect someone readily to admit if the property were sold at a profit.
11. If the taxpayer has several rental properties, some yielding a profit and some a loss, it is improper to apply REOP to the losing properties and ignore the profitable ones. The entire investment picture should be considered (Smith).
12. When to start a business and when to abandon it are business decisions in which neither the taxing authorities nor the court should intervene (Nichol). Nonetheless if losses go on being incurred year after year for an inordinate length of time sooner or later one has to apply what I shall call the "Enough is enough" principle and decide that what might have been a viable business has, with the efflux ion of time, became hopeless and the best thing to do with it is to give it a decent burial. Nonetheless, a businessman's judgement to maintain a business must be treated with great respect.
[10] I consider Judge Bowman's summary of these principles to be the most comprehensive to date. I want to now apply these principles to the facts in this case.
[11] In respect to the personal element I do not accept Respondent counsel's argument that there is a definate personal element here simply because the Appellants resided in the property for several years prior to renting the property. The property was renovated and then rented. The personal element aspect clearly ceased at the point in time when they vacated the property and attempted to rent to a tenant. There was a clear change in use of the property. On cross-examination the Appellants gave evidence that they did not use in any way the house or the barn located on the property. This evidence was otherwise unchallenged and I accept their evidence as direct, honest and straightforward. The entire property was treated as a rental after the renovations and their treatment of the property extinguished any personal element that had previously attached to it. An absence of this element, as stated by Judge Bowman, carries a great deal of weight in applying the reasonable expectation of profit test sparingly and with extreme care.
[12] The facts in this case clearly indicate that the Appellants researched the real estate market, assessed the trends after talking to lawyers, accountants, brokers and other professionals knowledgeable in the real estate and investment areas. The Appellants owned other properties which were acquired, then sold for significant profit. This was not their first venture into the real estate market. There was a type of prior experience - and a successful experience with a profit. With prior successful experience and armed with additional information obtained from individuals in this field, the Appellants made the decision to renovate and rent at a time when they fully expected to lease at a comfortably higher rent because of the type of high end property they could offer for rent and in a market where rents were expected to increase. There was no evidence adduced by Respondent counsel that would indicate that the Appellants' expectation of increased revenue was unreasonable or misguided at that time. Certainly there was no extensive formal written business plan but many lucrative businesses have been hatched from, as the Appellant Cathy Gill put it: "scribbles on the front of a file folder". Her projections at this time were merely formalized in writing at a later date in preparation for the hearing. Her projection of $1,600.00 monthly rental was certainly realistic based on the facts at that time and in fact correspondence of a local realtor states that $1,400.00 monthly would not be an unreasonable rental for this property at that particular time.
[13] In addition, she checked on potential property tax increases and ascertained there would be none over the next three or four years, with Gary Gill being able to complete maintenance and repair work which was also factored into the projections.
[14] However a recession occurred and the rental market changed - a factor, an important one, beyond the control of the Appellants. Their initial expectation of realizing a profit in the fourth year of renting could quite likely have been successful if the economic downturn in the market had not occurred. Their initial expectations and projections were based on the market trends between 1981 and 1991 - that as value of the property increased so would rental revenues.
[15] The anticipated rental revenues were based on an analysis of prevailing rentals and on professional advice. The expected returns did not materialize because the recession intervened forcing rentals and house values downward.
[16] The property, while being renovated, was close to fully financed. However with renovations complete, appraisals showed the property value to be $375,000.00 with approximate debt of $278,000.00. The Appellants' projections as estimated in the early 1990s would have realized a profit in year four if the market conditions had not changed. This period of start-up was certainly reasonable but with the intervening prolonged recession trends, this start-up period became lengthy. I do not agree with Respondent counsel that the Appellants took no concrete steps to address the changing market. They did take clear steps to mitigate their loss. They made numerous attempts to rent it for $1,600.00 monthly through ads, talking to people, etc. Only when it became clear that they could not immediately rent for this amount, did they decide to rent to a tenant who offered $900.00. They took that step to reduce losses and in an attempt to ride out the downturn in the market conditions.
[17] With the hope of finding a better tenant, they rented at $900.00 on a month-to-month basis so that this tenant could be asked to vacate on shorter notice. They did request the tenant to pay more rent, but he threatened to move out if it was increased. They also turned their mind to the problem by continuing to renew their mortgage for as short a period as possible so that lower interest rates could be maintained. Their actions were prudent given the circumstances.
[18] There was nothing in the facts of this case to suggest that the expenses associated with the rental property were anything but reasonable. And there was no evidence that the expenses were in any way related to personal or living expenses. It was clearly operated as a business.
[19] The oral evidence together with the appraisals presented, suggest that the market was beginning to change in 1996 and 1997. However the Appellants simply could not continue to hold on and made a decision to sell in 1997. There was evidence that if they had retained this property, the value was increasing as the market improved. Cathy Gill's evidence was that they were told to hold onto the property as the values would go up over time as would rentals, but as she put it, they "could not hold on to it any more". The last principle reviewed by Judge Bowman clearly states that it is a business decision of the taxpayer when to start a business and when to abandon it. The facts here are clear. The Appellants had a reasonable expectation of profit that was not "irrational, absurd or ridiculous. When they rented the property for a lesser amount it was with the hope of riding out the downward market trends which had commenced after their projections and renovations were completed. The recession however was prolonged. And when it became clear in the Appellants' circumstances that (as Judge Bowman put it) "Enough is enough", they made a business judgment to sell.
[20] The rental property was a business with a reasonable expectation of profit and was being held for the purpose of gaining income. Total terminal loss in 1997 agreed between the parties at a figure of $60,000.00 is allowed.
[21] The appeals are allowed and referred back to the Minister for reconsideration and reassessment to allow the Appellants the deduction of rental losses in the 1996 and 1997 taxation years together with terminal loss in the agreed upon total amount of $60,000.00 to be available to be applied against income for the 1994, 1995 and 1996 taxation years.
Signed at Ottawa, Canada, this 10th day of October 2001.
"D. Campbell"
J.T.C.C.
COURT FILE NO.: 2001-1284(IT)I
2001-1285(IT)I
STYLE OF CAUSE: Cathy Gill,
Gary Gill and
Her Majesty the Queen
PLACE OF HEARING: Toronto, Ontario
DATE OF HEARING: September 17 and 21 2001
REASONS FOR JUDGMENT BY: The Honourable Judge Diane Campbell
DATE OF ORAL JUDGMENT: October 10, 2001
APPEARANCES:
Counsel for the Appellant: John David Buote
Counsel for the Respondent: James Gorham
COUNSEL OF RECORD:
For the Appellant:
Name: John David Buote
Firm: Brampton, Ontario
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada