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Citation: 2005TCC488
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Date: 20050829
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Docket: 2005-785(IT)I
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BETWEEN:
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DARRELL FRANK NAUSS,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Bowman,
C.J.
[1] This
appeal is from an assessment for the appellant’s 2002 taxation year. It involves
the somewhat recondite question of the valuation of a life interest and a
remainder interest in real property. It arises in the context of a capital gain
realized by the appellant in 2002 on the disposition of real property. Before I come to the substantive issue
there are two points that should be disposed of.
[2] The
basic question is the computation of the appellant’s capital gain. The agent
for the appellant adduced evidence of other expenses incurred in connection
with the sale of the property. A major expense which was not recognized on
assessing was the real estate commission and legal fees totalling $23,001.85.
These should be allowed as a cost of disposition of the property, shared
between the appellant and his sister who had a one-half interest in the
property.
[3] There
are few other relatively small expenses claimed by the appellant as part of the
cost of disposition such as travel, repairs, food and incidentals. I do not
think it has been established that these expenses properly form part of the
cost of disposition of the property.
[4] A
second issue has to do with a number of expenses claimed by the appellant in
his business called the Knitting Nook. The parties now agree that $1,771.22 additional
expenses should be allowed as deductions in computing the appellant’s income.
[5] I
turn now to the issue of valuation.
[6] The
appellant’s grandmother, Reta Leone Eisnor was the owner of land and
buildings at 90 Eisenhauer Road, Oakland, Nova Scotia. The property had been in the Eisenhauer family (the
name became Eisnor at some point) since the 1700s. The house was built in 1764.
Paragraph 5 of Reta Eisnor’s last will dated 11 April, 1978,
read:
5. I GIVE AND DEVISE all of
my real property to my daughter, MARGARET LOUISE NAUSS, for her use during her
lifetime and upon her death I give that property to my grandchildren,
LEONE SUSAN RUSSELL and DARRELL FRANK NAUSS, equally,
share and share alike for their own use absolutely.
[7] Margaret Louise Nauss
was Mrs. Eisnor’s daughter and Leone Susan Russell and
Darrell Frank Nauss (the appellant) were the children of Margaret
Louise Nauss. Mrs. Eisnor died on September 15, 1997.
[8] The
last will and testament of Margaret Louise Nauss was dated
March 12, 1997. It provided in clause 6:
6. I GIVE, DEVISE AND
BEQUEATH all the rest, residue and remainder of my estate, of whatsoever nature
and kind and wheresoever situate (including any property over which I may have
a general power of appointment) to my husband, LLOYD LEAMAN NAUSS, as his own
property absolutely. In the event that my husband, LLOYD LEAMAN NAUSS, has
predeceased me, then I give all of the rest, residue and remainder of my estate
to my son, DARRELL FRANK NAUSS, and my daughter,
LEONA SUSAN RUSSELL, or the survivor of them alive at the time of my
death, equally share and share alike as their own property absolutely.
I mention Mrs. Nauss’ will simply for the sake of completeness. It is
not relevant to this case because the property was sold prior to her death.
[9] Mrs. Nauss and her husband lived in the property until 1997 when
they moved out. Mrs. Nauss died November 12, 2003 and her
husband died February 12, 2003.
[10] Before I come to the sale on November 29, 2002 giving rise to the
capital gain in question here it is useful to review the legal position that
existed upon the death of the grandmother, Mrs. Eisnor, until immediately
prior to the sale. When Mrs. Eisnor died she left a life interest to her
daughter, Mrs. Margaret Louise Nauss, and a remainder interest
to the appellant and his sister, Mrs. Russell. On September 15, 1997,
Mrs. Nauss was 70 years of age. Under paragraph 70(5)(b) of
the Income Tax Act the legatees of the property under Mrs. Eisnor’s
will are deemed to have acquired it at its fair market value (“fmv”) at the
date of death. In the result, Margaret Louise Nauss who at that time
was 70 years of age, acquired her life interest at its fmv and Mr. Nauss
and his sister, Mrs. Russell, each acquired 50 percent of the
remainder interest at its fmv.
[11] The life interest and the remainder interests together represent the
totality of the interest in the property capable of being owned, that is to
say, the fee simple.
[12] On November 29, 2002 the property was sold by means of a
Warranty Deed to Tye W. Burt. The grantors were
Darrell Frank Nauss, his sister Leona Susan Russell and
Margaret Louise Nauss. The appellant signed in his own capacity.
Leona Susan Russell signed in her own capacity and as attorney for
Margaret Louise Nauss and as attorney for Lloyd Leaman Nauss,
the husband of Margaret Louise Nauss. He was simply releasing any
claim that he might have under the Matrimonial Property Act of Nova Scotia.
Thus the entire interest in the property was disposed of and the price was
$385,000.
[13] The assessment was based on the view that the appellant and his wife
received the entire property in 1997 when the grandmother died. Therefore, the
capital gain was determined to be $385,000 less the assumed fmv on the date of
the grandmother’s death of $245,000 = $140,000. The appellant’s portion was
$70,000 and the taxable portion was $35,000.
[14] The respondent now admits that this view was wrong and takes the
position that the capital gain realized by the appellant and his sister should
be the difference between the fmv of their remainder interests on
September 15, 1997 and the portion of the proceeds of $385,000
attributable to the remainder interests. I agree with the principle. The numbers,
however, present something of a problem.
[15] The way the respondent says the gain should be calculated under the
new basis is set out below. The fmv of the entire property on
December 15, 1997, $245,000 was based on an appraisal provided by
Mrs. Russell’s husband. The appraiser called by the respondent,
Bill Chappell, looked at the appraisal and found it reasonable. The figure
in any event was not challenged and so I accept it. I have no other figure.
[16] The Crown’s new calculation is based on the following:
b) the Appellant
and his sister received a Remainderman Interest in the property in 1997 which
had a FMV of not more than $136,820, the Appellant’s 50% share being $68,410
($136,820 x 50%);
c) the Appellant’s
ACB of his Remainderman Interest was $68,410;
d) Margaret Louise Nauss
received a Life Interest in the property in 1997, which had a FMV of not less
than $108,180;
e) in 2002, the
entire property, consisting of both the Life Interest and the Remainderman
Interest, was sold for total proceeds of $385,000; and
f) the portion of
the proceeds that was attributable to the Remainderman Interest was not less
than $273,801, the Appellant’s 50% share being $136,900.50 ($273,801 x 50%).
12. The Appellant’s
taxable capital gain on the disposition of his Remainderman Interest in the
property in 2002 is properly calculated as follows:
Proceeds
of Disposition $136,900.50
ACB 68,410.00
Capital
Gain $ 68,490.50
Taxable
Capital Gain $34,245.25
The expert called
by the respondent, Mr. Chappell, is an experienced and competent real
estate appraiser. He admitted however that he had never valued life interests
or remainder interests and indeed had not even studied the valuation of such
interests in the courses he took to obtain his accreditation. I considered not
accepting him as an expert in this case despite his otherwise impressive
credentials and experience. However, we are in the informal procedure and I am
faced with the practical consideration that, if I did not, I would have to do
something with the appeal and the most reasonable thing to do was to hear what
his conclusions were and his reasons. I found him a candid and intelligent
witness and our discussion of the problem was helpful. In the informal
procedure we must obtain assistance from whatever sources are available.
[17] Mr. Chappell did do some research and he set out what strikes me
as a fairly reasonable starting point in valuing life interests and remainder
interests. The valuation of such interests is at best an imprecise calculation.
It is not like valuing a house in a subdivision where one can look to
comparable sales. Life interests and remainder interests are, after all, not exactly
a hot commodity on the real estate market. In any event, you either take the
total value and deduct from it the value of the remainder interest to arrive at
the value of the life interest or else you take the total value and deduct from
it the value of the life interest to arrive at the value of the remainder
interest. The latter method is difficult but the former is virtually impossible.
A life interest has a finite and, at least in theory, an ascertainable value.
You cannot determine a remainder interest in a vacuum or in the abstract. You
have to determine the value of the life interest first and excise it out of the
total value before you value the remainder interest.
[18] The virtual impossibility of determining the remainder interest in
some manner other than by first valuing the life interest is illustrated by the
following passage from Mr. Chappell’s report:
3.2.4. Method 1 Remainderman
Interest
In calculating the Remainderman Interest the first
step is to forecast the total future value of the subject property at the date
that the Life Estate is expected to expire (based on mortality tables). This
total future value is then discounted back to the effective date of valuation
to provide an indication of the total present worth of the value. This present
value is representative of the Remainderman Interest and indicates the current
value to the property owner. By deducting this Remainderman Interest from the
total fair market at the effective date one can arrive at the value of the Life
Interest as a residual value.
3.2.5 Method 2 Life Interest
The calculation of the Life Estate considers the
present value of the potential net revenue that the property may be capable of
producing. Only the Life Tenant has the right to receive rent from the property
during the life tenancy. With this method, an estimate of the income the
property can produce and the expenses it would incur must be estimated. The net
income is then capitalized at an appropriate rate to provide a present value of
the anticipated cash flow over the estimated term of the Life Interest based on
mortality tables. By deducting this Life Interest from the total fair market at
the effective date one can arrive at the value of the Remainderman Interest as
a residual value.
In the case of the subject property, the Remainderman
Interest is the interest that accrues to the grandchildren, Darrell Nauss
and Leone Russell. It is the value of the right to own the property when
the life estate is ultimately extinguished. A similar calculation was made for
both dates. The first date is the date that the Life Interest was created and
the second date is the date when the Life Interest was extinguished.
3.2.6 Remainderman Interest
In order to estimate the Remainderman Interest in the
property at each date we must follow 3 steps as noted above:
Step 1. Estimate the fair
market value of the property at the date the life estate was created –
September 1997 and the date of the sale of the property in November 2002.
Step 2. Forecast the future
value of the property when it is anticipated that the Life Interest will cease
to exist and the grandchildren will gain the fee simple interest in the
property. This must be done for each of the two dates.
Step 3. Discount that estimated
future value back to provide a present value based on the expected duration of
the life estate. This also must be done for each of the two dates.
In addressing the valuation issues we have broken the
process into two sections. The first addresses the value allocation as of the
date the Life Interest was created i.e. September 1997. The second addresses
the value allocation as of the date the Life Interest was extinguished i.e.
November 2002.
In the result we have to start by valuing the life interest at the two
dates – December 15, 1997 and November 27, 2002.
[19] I come back to the Crown’s calculations set out above. A few things
strike me as interesting, if not peculiar. The first is that Mr. Nauss’ taxable
capital gain on the new calculations is $34,245 whereas the capital gain on the
old and erroneous assumption that Mr. Nauss and his sister got the entire
fee simple in 1997 and sold it in 2002 results in a taxable capital gain for
him of $35,000 – a difference of only $755. This despite the fact that
Mr. Nauss’ mother in 1997 at 70 had an actuarial life expectancy of 16.02
years and in 2002 of 12.44 years. Another thing that is somewhat odd is that
according to the above calculations the fmv of the life interest in 1997 as
calculated by the Minister’s expert is $108,180 whereas five years later in
2002 when Mrs. Nauss was 75 the fmv of her life interest was $111,199. Now
it is true that the overall value of the property rose by $140,000 from
$245,000 to $385,000. A purely mathematical calculation would look something
like this, assuming the fmv of the life interest to be $108,180 in 1997:
$108,180 X 385,000 = 169,997 X 12.44 =
132,007.76
245,000 16.02
[20] It should also be borne in mind that the use of any factor that
increases the proportion of the entire value that is attributable to the
remainder interest is a two-edged sword. In 1997 it increases the appellant’s adjusted
cost base of the remainder interest. In 2002 it also increases the proportion
of $385,000 that is attributable to the sale of the remainder interest so that
the capital gain on the sale of the remainder interest is adjusted both ways
and remains relatively constant.
[21] According to Mr. Chappell the life interest on
September 15, 1997 was 44.15 percent of the total value whereas
on November 22, 2002, it represented 35.55 percent of the total. This is
roughly consistent with the fact that Mrs. Nauss’ actuarial life
expectancy had declined from 16.02 years to 12.44 years. It is interesting,
albeit irrelevant, that statistically Mrs. Nauss was expected in 2002 to
live for 12.44 years whereas she in fact died on November 12, 2003. It
certainly proves the truth of the statement that we know neither the day nor
the hour.
[22] The question of using the actual date of death rather than actuarial
mortality tables arose in Ithaca Trust Co. v. United States,
279 U.S. 151. The answer seems obvious – the actuarial tables should
be used. However, I am pleased that this view was confirmed by no less an
authority than Justice Oliver Wendell Holmes, who said at pages
154-5:
The
second question is raised by the accident of the widow having died within the
year granted by the statute, section 404, and regulations, for filing the
return showing the deductions allowed by section 403, the value of the net
estate and the tax paid or payable thereon. By section 403(a)(3) the net estate
taxed is ascertained by deducting among other things gifts to charity such as
were made in this case. But as those gifts were subject to the life estate of
the widow of course their value was diminished by the postponement that would
last while the widow lived. The question is whether the amount of the
diminution, that is, the length of the postponement, is to be determined by the
event as it turned out, of the widow's death within six months, or by mortality
tables showing the probabilities as they stood on the day when the testator
died. The first impression is that it is absurd to resort to statistical
probabilities when you know the fact. But this is due to inaccurate thinking.
The estate so far as may be is settled as of the date of the testator's death.
The tax is on the act of the testator not on the receipt of property by the
legatees. Therefore the value of the thing to be taxed must be estimated as of
the time when the act is done. But the value of property at a given time
depends upon the relative intensity of the social desire for it at that time,
expressed in the money that it would bring in the market. Like all values, as
the word is used by the law, it depends largely on more or less certain
prophecies of the future, and the value is no less real at that time if later
the prophecy turns out false than when it comes out true. Tempting as it is to
correct uncertain probabilities by the now certain fact, we are of opinion that
it cannot be done, but that the value of the wife's life interest must be
estimated by the mortality tables. Our opinion is not changed by the necessary
exceptions to the general rule specifically made by the act.
(Case law citations omitted)
The same view was expressed by Frank, Circuit Judge in Commissioner of
Internal Revenue v. Marshall, 141 A.L.R. 445, 125 F.2d 943 at 946. (Circuit
Court of Appeals, Second Circuit.)
It
is also argued that Congress could not have intended to be so unjust as to
impose a tax based upon an estimate of value, taken from the mortality tables,
which may turn out to be not in accordance with reality. Thus the Board refers
to the fact that, under Section 510, the donee of a gift may be personally
liable for a gift tax not otherwise paid 'to the extent of the value of such
gift'; suppose, then, argues the Board, that the children, under that section,
were required to pay a tax on the value of their remainders at the date of the
gift, computed actuarially, and that the life tenants die while the donor still
lives; in such circumstances, says the Board, 43 B.T.A. 99, 'the children would
thus have paid a gift tax on something which they never received'.
That argument proves too much. It would
preclude a tax on any 'value' which is not almost certain to correspond with
actual enjoyment. But 'value' seldom does so correspond. The fallacy in that
argument stems largely from lack of recognition of the eely character of the
word 'value'. It is a bewitching word which, for years, has disturbed mental
peace and caused numerous useless debates. Perhaps it would be better for the
peace of men's minds if the word were abolished.7 Reams of good
paper and gallons of good ink have been wasted by those who have tried to give
it a constant and precise meaning. The truth is that it has different meanings
in different contexts,8 even in the restricted field of 'tax law'.9
And there, as almost always, 'value' involves a conjecture, a guess, a
prediction, a prophecy. With reference to the taxation of life estates, the
Supreme Court has relied on educated guesses, as of a given date, based on the
mortality tables, disregarding the fact that actually, in the particular case
before it, the prophecy has turned out to be wrong because the life tenant did
not live up to her life expectancy. 'Like all values, as the word is used by
the law, it depends largely on more or less certain prophecies of the future;
and the value is no less real * * * if later the prophecy turns out false than
when it comes out true. ' Ithaca Trust Co. v. United States, 279 U.S. 151, 155, 49
S.Ct. 291, 292, 73 L.Ed. 647. The rationale of that case is controlling here.
Treasury Regs. 79, Art. 19 adopts the actuarial method of valuing remainders.
That method is not so arbitrary as to be unreasonable and invalid.
It
is immaterial that actuarial estimates may not accord with realities. Few
estimates of value do, whether used by courts or laymen: For purposes of
corporate reorganization, value, generally, is a reasonable capitalization of
future earnings as reasonably foreseeable at the date of reorganization;
reliance is had upon an educated guess or peering into the future, which, being
a human conjecture, may be wrong. No one can foretell what changes in
technology will do to the earnings of any business.10 Anyone who
wants to eliminate uncertainties from 'value' will have a sad time getting
along in this world. All aspects of living are chancy. We cannot, by the use of
a symbol, 'value', convert the risky into risklessness, Canute restless change
out of existence. Businessmen sometimes pay cash for value which exists only in
'moonshin or dreamland'.11 That 'market value', for instance, in the
case of city real estate, is often a mirage, has been strikingly shown by
Abrams, Revolution in Land (1939) 198-200, cf. 132-133, 81-89. Accordingly, we
reject the argument that, merely because the 'value' of the contingent
remainders, measured actuarially, may be inaccurate, Congress must be deemed to
have intended that such remainders should not be subject to a gift tax.
(Footnotes omitted)
[23] We all know the definition of fmv in Henderson Estate v. M.N.R., 73 DTC
5471. Nonetheless the determination of the value of life interests and
remainder interests is at best an imprecise exercise. It is based on a variety
of imponderables not the least of which are actuarial mortality tables and
capitalization rates. Mr. Chappell also looked at residential rental rates
which he projected to 2013 and then discounted them at 12 percent to 1997
to arrive at a fmv for the life interest of $89,869. Whether it is in 2005
possible to predict rental rates in Nova Scotia in 2013 while
theoretically standing in 1997, or to use as appropriate a discount rate of
12 percent, or whether it is acceptable to use residential rental rates in
valuing a 250 year old historic property is open to question. The assumptions
upon which such calculations are based vary within a range of indeterminate
magnitude. At all events the computation results in a fmv for the remainder
interest of $155,131 ($245,000 - $89,969 = $155,131) on September 15,
1997. The exercise that I performed above would increase the fmv of the life
interest in 2002 as follows:
$ 89,869 X 385,000 = 141,222 X 12.44 =
109,663.00
245,000 16.02
[24] On this basis we would attribute $275,337 to the remainder interest in
2002 ($385,000 less $109,663) and the capital gain would be $275,337 minus
$155,131 = $120,205 ÷ 2 = $60,102.50. Mr. Nauss’ taxable capital gain is
$30,051.25. I daresay I could do some more tinkering and fine tuning but it
would not make an appreciable difference.
[25] This strikes me as a somewhat more reasonable result than that arrived
at by the Minister. I do not think it is reasonable to base a valuation of the
remainder interests on hypotheses and premises that result in the capital gain
on the sale of the remainder interests being virtually identical to that
realized on the sale of the entire fee simple. The result appeals as much to my
common sense as to my sense of mathematical or logical congruity. As
Viscount Simon said in Gold Coast Selection Trust v. Humphrey,
[1948] A.C. 459 at 472:
In my view, the principle
to be applied is the following. In cases such as this, when a trader in the
course of his trade receives a new and valuable asset, not being money, as the
result of sale or exchange, that asset, for the purpose of computing the annual
profits or gains arising or accruing to him from his trade, should be valued as
at the end of the accounting period in which it was received, even though it is
neither realized nor realizable till later. The fact that it cannot be realized
at once may reduce its present value, but that is no reason for treating it,
for the purposes of income tax, as though it had no value until it could be
realized. If the asset takes the form of fully paid shares, the valuation will
take into account not only the terms of the agreement but a number of other
factors, such as prospective yield, marketability, the general outlook for the
type of business of the company which has allotted the shares, the result of a
contemporary prospectus offering similar shares for subscription, the capital
position of the company, and so forth. There may also be an element of value in
the fact that the holding of the shares gives control of the company. If the
asset is difficult to value but is none the less of a money value, the best
valuation possible must be made. Valuation is an art, not an exact science.
Mathematical certainty is not demanded nor indeed is it possible. It is for the
commissioners to express in the money value attributed by them to the asset
their estimate, and this is a conclusion of fact to be drawn from the evidence
before them.
[Emphasis added]
This passage has frequently been cited and followed and it illustrates in
my view the need to keep in mind some sense of reality and common sense in
valuing property that is hard to value.
[26] In light of the paucity of helpful material in this area, I looked to
foreign sources to see how other jurisdictions dealt with the matter of valuing
life and remainder interests. The United States yielded
a substantial amount of material but it was of no assistance because regulations
under the Internal Revenue Code prescribe specific proportions to be ascribed
to life estate and remainder interests. For example, for a person of 70 years
the split between a life estate and a remainder interest is .36617 and .63383.
For a person of 75 it would be .30375 and .69625. If I were required or
entitled to use these figures the life estate and remainder interest in 1997
would have a value of $89,711.65 and $155,288.35, respectively. In 2002, when
the mother was 75, they would be $116,943.75 and $268,056.25, respectively
based on a fmv of the fee simple in 1997 of $245,000 and in 2002, $385,000.
[27] Thus the capital gain on the remainder interest would be $112,767.90 and
the taxable capital gain would be $56,383.95 and Mr. Nauss’ share of the
taxable capital gain (before costs of disposition) would be $28,191.98. I
mention this simply to illustrate the discrepancy that may result from different
methods. However, whatever value the tables prescribed by the IRS may have in
the United States, they have none here and cannot be used
without an evidentiary foundation being laid. Nonetheless, I suspect that the
figures in the tables are actuarially sound although this conclusion is not
based on anything presented in the evidence in this case. It is interesting
however that the figure of $28,191.98 arrived by the use of the United States tables is relatively close to my figure
of $30,051.25.
[28] The appeal will therefore be allowed with costs in accordance with the
tariff on the following basis:
(a) the appellant’s
taxable capital before taking into account the real estate commissions and
legal fees is $30,051.25.
(b) the real estate
commissions and legal fees totalling $23,001.85 referred to at the beginning of
these reasons should be taken into account in determining the capital gain.
(c) the expenses
agreed to by the parties in relation to the appellant’s knitting business in
the amount of $1,771.22 are to be allowed in computing the appellant’s income.
Signed at Ottawa, Canada, this 30th
day of August 2005.
Bowman,
C.J.
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