Caradonna v. The Queen, docket 2001-365-IT-I (Informal Procedure)

Date: 20020419

Docket: 2001-365-IT-I

BETWEEN:

SAM CARADONNA,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasonsfor Judgment

Miller, J.T.C.C.

[1]            This is an appeal by Mr. Sam Caradonna by way of the informal procedure against the Minister of National Revenue's (the "Minister") denial of his rental losses for the 1996, 1997 and 1998 taxation years. This is the not uncommon situation of a taxpayer renting a part of his home and the Minister not allowing the deductions beyond income, on the basis that the rental arrangement did not have a reasonable expectation of profit.

[2]            In 1992, Mr. Caradonna bought a three bedroom townhouse condominium in Burlington, Ontario for $127,000. He indicated that he acquired the property to live in. Shortly thereafter he decided to rent out a room, which he did in 1993. From then until 1999, he had three tenants, though during 1996, 1997 and 1998 he had just the one tenant. Mr. Caradonna claimed he obtained his tenants by advertising.

[3]            The arrangement with his tenant in the relevant years was that the tenant had access to all of the townhouse other than Mr. Caradonna's master bedroom and a room which served as an office. The garage was used for storage, and likewise was available for the tenant's use.

[4]            For the 1996, 1997 and 1998 taxation years, the Appellant reported a gross rental income, expenses (before capital cost allowance) and losses from renting as follows:

Gross Rental Income Expenses Advertising Insurance Interest *Maintenance & repairs *Management & admin. Fees Motor vehicle expenses *Office *Legal, accounting & Other professional fees Property taxes Utilities Condo fees Total Expenses - Less Personal - 50% Portion of Expenses - Net Expenses Net Rental Loss

1996 $4,260.00 80.00 250.00 7,692.27 2,472.00 50.00 1,200.00 2,995.00 150.00 1,689.47 1,725.00 2,780.00 $21,023.72 10,511.88 $10,511.88 $ 6,251.88

1997 $4,500.00 - - - -    236.52 6,732,36 3,688,59 240,00 1,375,00 1,748,00 300.00 1,670.78 1,587.20 2,484.00 $20,062.45 10,031.23 $10,031.22 $ 5,531.22

1998 $4,500.00 - - - - 240.00 7,672,39 1,895.00 500.00 1,500.00 725.00 220.00 1,785.19 1,779.00 2,496.00 $18,812.58 9,406.30 $ 9,406.28 $ 4,906.28

[5]            I have asterisked those items which Mr. Caradonna conceded at trial were inappropriate to claim as deductible expenses pertaining to the tenancy. With respect to the automobile expenses, Mr. Caradonna advised that these were incurred in bringing to the condo supplies needed in completing renovations on the property. He did not provide any documents supporting the automobile expenses.

[6]            For the three years before and the year after the years in question, Mr. Caradonna reported a gross rental income and net rental losses from the property as follows :

                                                                Gross                       Net

                                Year                        Income                    Loss

                                                1993                         $1,200                      $ 519

                                                1994                         $3,600                      $3,797

                                                1995                         $3,275                      $5,433

                                                1999                         $5,700                      $1,262

[7]            Mr. Caradonna increased the rent in 1999 as the market was capable at that point of commanding a higher rate. Yet Mr. Caradonna also testified he decided to sell the property in 2000 as it was not profitable. Later in his testimony he also stated that he moved in 2000 because he had married.

[8]            In the Reply the Respondent framed his argument as follows :

1.              The disallowed rental expenses were not incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the Income Tax Act (the "Act");

2.              The Appellant did not have a reasonable expectation of profit from renting part of the Property in the 1996, 1997 and 1998 taxation years, that the losses were personal or living expenses of the Appellant, and that the Appellant was properly reassessed in accordance with paragraphs 18(1)(a) and 18(1) (h) of the Act; and

3.              In the Alternative, he submits that the disallowed rental expenses were not reasonable in the circumstances and are not deductible from income pursuant to section 67 of the Act.

[9]            In argument at trial the Respondent relied not on the application of paragraphs 18(1)(a) and (h) of the Income Tax Act (the "Act") but on the reasonable expectation of profit ("REOP") test, stemming from Moldowan v. The Queen, [1974] F.J.C. No. 801. He also concluded with the alternative argument of the expenses being unreasonable, should I find the REOP test has been met. The differing approaches between the pleadings and oral argument drove home to me how fuzzy this area has become, and in some respects how illogical, by the attempts to interweave what I will call the Moldowan REOP test and the applicable sections of the Act, being 18(1)(a), (h) (which of course includes the statutory REOP test in the definition of "personal or living expenses") and section 67.

[10]          Before turning to the Moldowan REOP test, I wish to clarify how I perceive this test is to be applied in rental property cases. Without going through the extensive and somewhat chequered history of the so-called REOP doctrine, given hopefully some impending guidance from the Supreme Court of Canada, I would state that I see a distinction in rental property cases between the Moldowan REOP test and the statutory REOP test found in the definition of "personal or living expenses". I believe the former is an objective test while the latter is a subjective test. While in many cases this may make no difference at all, I am now faced with a case where the distinction is relevant.

[11]          In Donyina v. Canada, [2001] T.C.J. No. 456, Associate Chief Judge Bowman helpfully listed a number of principles that have moulded the Moldowan REOP test over the years. He refers to the statutory test contained in the definition of "personal or living expenses", stating that if the expenses are not personal or living expenses, then the REOP test must be applied with extreme care. Given the statutory REOP test may already have been applied, in determining whether expenses are personal or living, this is a recognition by Associate Chief Judge Bowman of the two REOP tests. I maintain though that the statutory test, by its very wording, requires a subjective analysis. It refers to a "business carried on with a reasonable expectation of profit". Even though dealing with income from property, to get around this element in the definition of personal or living expenses, a taxpayer must prove there was a business, and that the business was carried on (presumably by the taxpayer) with a reasonable expectation of profit. This requires delving into the taxpayer's mind, which necessarily means looking at the circumstances as the Appellant looked at them to determine the reasonableness of the taxpayer's expectation — a classic subjective approach.

[12]          With respect to the Moldowan test, in Kaye v. The Queen, 98 DTC 1659, Associate Chief Bowman posed the REOP as follows:

[5]            One cannot view the reasonableness of the expectation of profit in isolation. One must ask "Would a reasonable person, looking at a particular activity and applying ordinary standards of commercial common sense, say 'yes, this is a business'?" In answering this question the hypothetical reasonable person would look at such things as capitalization, knowledge of the participant and time spent. He or she would also consider whether the person claiming to be in business has gone about it in an orderly, businesslike way and in the way that a business person would normally be expected to do.

[13]          This is a classic objective test. I suggest one needs to twist that test slightly to apply it to income from property, but still retaining the objective nature of the test. In Mr. Caradonna's case, the question is whether a reasonable person would expect a profit from a property where the operating costs of interest, utilities, property taxes and condo fees are known, as is the fair market value rental for having one tenant share the premises. It is not open to second guess Mr. Caradonna by suggesting his initial mortgage should have been lower or he should have rented two rooms. Both the subjective and objective tests require a similar starting point.

[14]          Which test does one apply first in dealing with rental losses? The Moldowan test I have described in earlier cases as a gate keeping test; if you don't pass that test and prove a source of income, you need go no further into the Act than section 3 — you are simply not in. Logically, this test, the objective test, should be applied first.

[15]          What would the reasonable business person expect from Mr. Caradonna's property? With respect to expenses, certainly the mortgage interest, the taxes, the utilities and condo fees would be anticipated, but I would suggest no other expenses, other than minor maintenance costs. These expenses averaged around $13,700 per year, or $14,000 a year if you calculate in some reasonable maintenance costs.

[16]          In objectively viewing the living arrangements the impartial observer might well determine a slightly higher percentage of usage to Mr. Caradonna than the tenant. Mr. Caradonna had the office and the master bedroom with the ensuite. He was also the decision maker on when and how problems with the condo were dealt with, and he owned and cared for all the condo's contents other than the tenant's personal belongings. A 60-40 split would be reasonable. This would result in a reasonable expectation of expenses related to the tenancy of 40 percent of $14,000 or $5,600. Could a landlord expect income in excess of that, that is a monthly rent of greater than $465 a month? This does not seem unreasonable and indeed Mr. Caradonna received more than that in 1999. I find that the Moldowan test can be met, establishing that there is a source of income, in this case, property, subject now to the application of the other provisions of the Act. I suggest there is a distinction between business income and property income cases, as the Moldowan test can be applied in property cases in a way that does not require a finding of a business; I need only find that there is a property which can reasonably sustain a profit. I need not look into all those other characteristics of carrying on a business.

[17]          I find the Moldowan REOP test has been met, notwithstanding my view that Mr. Caradonna would not pass a subjective application of the REOP test, as found in the definition of "personal or living expenses". Mr. Caradonna clearly had it in mind to deduct significantly greater expenses than those just reviewed, as well as maintaining that the expense of renting one room of his three bedroom condo justified a 50-50 allocation of those expenses. I would have no difficulty finding Mr. Caradonna was not carrying on a business with a reasonable expectation of profit.

[18]          It follows that I should now apply the other provisions of the Act in determining Mr. Caradonna's losses. While it may seem logical to address paragraphs 18(1)(a) and (h) at this point, the difficulty is that the Minister has already allowed expenses up to the amount of the rental income; presumably on the basis they were incurred for the purpose of gaining or producing income and were not personal or living expenses. The Minister therefore acknowledges that some expenses are deductible, yet some are not, solely on the basis that expenses are only deductible to offset income and no more. This is a dangerous principle to accept: that expenses can only be found to be incurred for the purpose of gaining or producing income up to the amount of income actually produced. No losses would ever be allowed. Once the Minister accepts any allocation to the tenancy, there is a recognition that expenses were incurred for the purpose of gaining or producing income, and now the appropriate question to be asked is the reasonableness of those expenses. Once by the Moldowan REOP test, then the question in this case should not really be whether the expenses in excess of income were incurred for the purpose of gaining or producing income, but should simply be what expenses are reasonable, relying on section 67. I turn to this analysis next.

[19]          Mr. Caradonna conceded at trial that the expenses asterisked in the schedule of expenses stated previously were not appropriate for deduction. I further find that his claimed automobile expenses are unsupported and unreasonable in the context of renting one bedroom of his home. This results in reasonable expenses for the three years in question of $14,266, $13,709 and $13,972. What is a reasonable apportionment of those expenses to the tenancy? A 50-50 split is not reasonable, notwithstanding the apparent liberal access to parts of the condo by the tenant. The tenant still did not have the same degree of care and control of the property as Mr. Caradonna. The allocation to the tenancy should be less than the 50 percent, though more than a one third that the rental of one of three bedrooms might suggest. I fall back, therefore, on the 40 percent figure suggested in my analysis of the objective REOP test. This results in expenses for 1996, 1997 and 1998 of $5,706, $5,483 and $5,588 with corresponding income of $4,260, $4,500 and $4,500, leaving losses of $1,226, $1,083 and $1,088.

[20]          I reach this result applying a reasonableness test in keeping with Justice Robertson's comments in Mohammad v. The Queen, [1997] 3 C.T.C. 321, wherein he stated:

30             In my respectful view, to disallow the deduction of a portion of the interest because of 100% financing is to establish a criterion of arbitrariness and to effectively supplant, erroneously and unjustifiably, the reasonable expectation of profit test with section 67 of the Act. The decision below is arbitrary because there is no principled basis on which to determine the amount by which the interest expense must be reduced. ...

..

32             From the above reasons, the following key conclusions may be drawn. The judicial doctrine of reasonable expectation of profit and the concept of reasonable expenses under section 67 of the Act are to be invoked and applied independently of one another. The temptation to use section 67 in an arbitrary manner simply to soften the strictures of the reasonable expectation test must be ignored. Granted, the nature of section 67 is more subtle than that of the reasonable expectation doctrine which is inherently an "all or nothing" test: either one does or does not have the requisite expectation; there is no middle ground. Nevertheless, section 67 must be applied in a reasoned manner and as objectively as possible. ... Correlatively, whether or not an otherwise deductible expense is reasonable in the circumstances is not to be assessed by reference to whether any one expense, or the collective expenses, are considered to be disproportionate to revenues.

[21]          By identifying the portion of the property which reasonably relates to the tenancy, I have attempted objectively to act in a reasoned manner, looking at the actual living arrangements. This is not arbitrarily reducing interest expense but simply establishing the extent to which those and the other legitimate expenses pertain to the lease. This analysis of reasonable expenses is independent of any reference to their proportion of revenues. It is also independent, as recommended by Justice Robertson of the REOP analysis. I believe this is the role of the reasonableness test set forth in section 67 of the Act. I find further support for this approach from the wording of paragraph 4(1)(a), which reads:

4(1)          For the purposes of this Act,

(a)            a taxpayer's income or loss for a taxation year from an office, employment, business, property or other source, or from sources in a particular place, is the taxpayer's income or loss, as the case may be, computed in accordance with this Act on the assumption that the taxpayer had during the taxation year no income or loss except from that source or no income or loss except from those sources, as the case may be, and was allowed no deductions in computing the taxpayer's income for the taxation year except such deductions as may reasonably be regarded as wholly applicable to that source or to those sources, as the case may be, and except such part of any other deductions as may reasonably be regarded as applicable thereto; and

...

[22]          This is an exercise in determining such deductions as may reasonably be regarded as wholly applicable to the portion of the property that represents a source of income.

[23]          I wish to stress that my comments in this matter are confined to income from property cases, as I do distinguish them from income from business situations, on the basis one can have income from property without in fact being in business. I recognize this does result in allowing losses to a taxpayer who could not pass the subjective REOP test. I am satisfied however that there is a source of income, being Mr. Caradonna's property, and an analysis of the expenses reasonable in the circumstances leads to allowing Mr. Caradonna's appeal and referring the matter back to the Minister on the basis that Mr. Caradonna is entitled to losses from property in 1996, 1997 and 1998 of $1,226, $1,083 and $1,088.

Signed at Ottawa, Canada, this 19th day of April, 2002.

"Campbell J. Miller

J.T.C.C.

COURT FILE NO.:                                                 2001-365(IT)I

STYLE OF CAUSE:                                               Sam Caradonna and Her Majesty The Queen

PLACE OF HEARING:                                         Hamilton, Ontario

DATE OF HEARING:                                           April 10, 2002

REASONS FOR JUDGMENT BY:      The Hon. Judge Campbell J. Miller

DATE OF JUDGMENT:                                       April 19, 2002

APPEARANCES:

For the Appellant:                                                 The Appellant himself

Counsel for the Respondent:              Brent Cuddy

COUNSEL OF RECORD:

For the Appellant:                

For the Respondent:                             Morris Rosenberg

                                                                                Deputy Attorney General of Canada

                                                                                                Ottawa, Canada

2001-365(IT)I

BETWEEN:

SAM CARADONNA,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Appeals heard on April 10, 2002 at Hamilton, Ontario by

the Honourable Judge Campbell J. Miller

Appearances

For the Appellant:                                         The Appellant himself

Counsel for the Respondent:                         Brent Cuddy

JUDGMENT

The appeals from the assessments made under the Income Tax Act for the 1996, 1997 and 1998 taxation years are allowed, and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment, in accordance with the attached Reasons for Judgment.

Signed at Ottawa, Canada, this 19th day of April, 2002.

"Campbell J. Miller"

J.T.C.C.