Julien v. The Queen, docket 1999-3683-IT-I (Informal Procedure)

Date: 20000616

Docket: 1999-3683-IT-I

BETWEEN:

ROGER A. JULIEN,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasonsfor Judgment

O'Connor, J.T.C.C.

[1]            These appeals were heard at Toronto, Ontario on June 5, 2000. Testimony was given by the Appellant, assisted by his agent Bernard Faibish, and several exhibits were filed.

Issue

[2]            The issue in these appeals is whether the Appellant, in the years 1987, 1988, 1989, 1990, 1991 and 1992, was entitled to deduct from income certain rental losses from a property located at 310 Elmgrove Street, Oshawa, Ontario (the "Property"). The answer to this will involve a determination of whether, in those years, the Appellant had a reasonable expectation of profit.

Facts

[3]            The basic facts are as follows:

1.              The Appellant purchased the Property which consists of a one and one-half story house in front and a detached two-story garage/workshop ("shop") in rear in August of 1984 for a price of $79,000.

2.              The Appellant's stated intention in making this purchase was to rent the house and eventually use the shop for a business that he would operate consisting principally in the making and remodelling of cabinets.

3.              The Appellant financed 100% of the purchase price for the Property with a first mortgage in the amount of $70,000 and a loan of $10,000 from his sister. In 1986 the Appellant obtained additional financing on the Property with a second mortgage in the amount of $29,300. The Appellant used $10,000 of said amount to repay his sister the loan of $10,000. The balance of $19,300 was used to cover expenditures made from 1984 to 1986. The precise nature of these expenditures was not explained.

4.              The Appellant refinanced the Property on March 1, 1988 with a new first mortgage of $108,500 and on October 6, 1988 a new second mortgage of $35,000. The Appellant used part of the $108,500 to pay off the outstanding amount of $64,960 on the initial first mortgage and the outstanding amount of $31,152 on the initial second mortgage. The remainder of the $108,500 was disbursed as follows: Legal and Brokerage fees $1,345, Consumers Gas $2,098 and approximately $9,000 for cash flow purposes intended to cover renovations. According to the Appellant, the $35,000 second mortgage funds were used for renovations, mortgage payments and personal matters, but detailed proof was not given.

5.              At the time the Appellant purchased the Property, he resided in a townhouse in Oshawa and worked at Vanier Collegiate in Oshawa as an industrial arts teacher.

6.              In September, 1984 the Appellant was appointed to Department Head at Anderson Collegiate in Whitby, Ontario.

7.              The Appellant suffered rental losses from the Property in 1984. He filed no returns for 1985 and 1986. For 1987 and 1988 the Appellant claimed rental losses from the Property in the amounts of $4,127 for 1987 and $10,975 for 1988.

8.              For the years 1989 through 1992 the details of the gross rental income, expenses and losses are as follows:

	1989	1990	1991	1992
Gross Rental Income	$10,800	$ 8,550	$11,400	$11,400
Expenses
Property taxes	$ 1,509	$ 2,496	$ -	$ 2,835
Maintenance & repairs	1,030	1,284	1,068	4,410
Interest	16,714	17,446	16,583	15,637
Insurance	325	345	404	478
Light, heat & water	521	531	242	-
Other	66	-	66	-
Advertising	-	236	-	-
Total Expenses	$20,165	$22,338	$18,363	23,360
Less Personal Portion                 of Expenses	-	-	-	808
Net Expenses	$20,165	$22,338	$18,363	$22,552
Net Rental Loss	$ 9,365	$13,788	$6,963	$11,152

(The rental loss in 1990 may have been approximately $16,000 as appears from an amendment made to the return for that year, but this is not material).

                For 1993, 1994 and 1995 the gross income and net losses were as follows:

Year	Gross Income	Net Loss
1993	$11,400.00	$3,347.00
1994	$10,450.00	$1,945.00
1995	$7,200.00	$4,592.00

9.              During the years in question the Appellant had employment income from his teaching profession of approximately $60,000 to $70,000 per annum.

10.            The following is a summary of the tenants that occupied the Property and related details:

                August, 1984 to May 1986                                  John Mackenzie (the original vendor) and for a time in this period the shop was rented to a Mr. Kelly

                Mr. Mackenzie occupied both the house and the shop and continued to operate a successful electronic repair business until May 1986 when he retired and emigrated to England. Mr. Mackenzie's monthly rent was $600 for the residence and $400 for the shop. The reason Mr. Mackenzie stayed on and continued the business after the sale of the Property in August, 1984 and until May, 1986 was that he was unable to find any buyer of the business he carried on in the shop. Mr. Kelly's monthly rent for the shop was $400. During this time the Appellant had access to the second floor of this shop to do basic renovations consisting of clean-up and installation of insulation. It was the Appellant's intention eventually to operate a cabinet manufacturing business from the shop. The Appellant put this venture on hold when he was appointed Department Head of the vocational section of Anderson Collegiate Institute in September, 1984.

11.            A Mr. Paul Jensen leased the shop from May, 1986 to August, 1987 and operated therein a pinball machine repair shop. During that tenancy the Appellant also made further renovations to the shop. The rent Mr. Jensen paid for the shop was $400 per month.

12.            During the period August, 1987 through December, 1991 the entire property, namely the residence and the shop was leased initially to a Susan Smith and then to a "Williams Family". The rent paid during these two time periods was approximately $950 per month. The shop was not during these periods operated as a business but was made available to the tenants for storage purposes.

13.            During the period January, 1992 through November, 1994 the whole property again was leased to a Leslie Poole and Hilda Hood, again at the rate of $950 per month.

14.            Since no business was being operated from the shop, after a period of time, the previous zoning of commercial non-conforming lapsed and the shop then became zoned residential. However, the condition of the shop, mainly its lack of water and sewer supply and other matters rendered it unrentable for residential purposes. Had the Appellant attempted to rent in its then state and condition he would have faced severe fines from the municipality. Thus, he was essentially unable to rent the shop, either for business purposes or as a residence.

15.            The Appellant asserts that the main reason he did not renovate the shop to conform with residential requirements was the exorbitant cost, in particular, an estimated amount of $35,000 for digging a large trench and installing sewer and water services with further expenses for shoring up the neighbouring driveway. Thus the renovations to convert the shop to a residence were delayed. The Appellant added that he was awaiting the introduction of Ontario legislation which would permit the water and sewer connections to be made by connecting with the existing system in the house. Apparently this process had been developed in Australia and could be achieved at a very low cost. The Appellant had read about it and thought that that was the most expedient way to proceed, i.e., to wait for legislation which would enable him to make such a connection direct from the house to the shop. In support of his contention, Bill 120, which was adopted by the Ontario Legislature on May 31, 1994 was submitted. It was the Appellant's contention that until this bill was adopted he could not have made the connections from the house, although that fact was not definitely proved.

Submissions of the Appellant

[4]            The Appellant submits through his agent that the losses resulted from causes beyond the control of the Appellant. These consisted mainly in the fact of his having reasonably accepted his new position at Anderson Collegiate in September, 1984, thus considerably reducing the time he could devote to the renovations and to the operation of a business. He submits further that he could not make the renovations as the proposed legislation had not been adopted until 1994 and that his stay in London while teaching at Anderson made it difficult travel-wise to contemplate the renovations and start-up of the business.

Submissions of the Respondent

[5]            Counsel for the Respondent referred to the authorities, some of which will be referred to later. Counsel submitted that there was a personal element involved in the proposed cabinet making operation. He stated further that the considerably reduced loss in 1993 compared to previous years was not attributable to anything other than the fact that the Appellant, in the return for that year, decided to attribute a considerable amount of the expenses to his personal use of the house. Counsel submits that that attribution was unreasonable as in that year the Appellant only occupied a basement apartment in the house. Further, although minor profits in 1996 and in 1997 may have been achieved, I should ignore those later year profits. Counsel further argued that the interest on some of the mortgage funds, principally the $35,000 second mortgage in 1988, should not be allowed because the Appellant has not proved that the funds borrowed related to the Property. Counsel pointed out further that some of the maintenance and repair items were capital in nature and consequently should not be allowed. Counsel's principal argument however is that throughout all of the years in question, as well as in 1993, 1994 and 1995, the rentals were not sufficient to even meet the fixed costs of mortgage interest and taxes. He referred to authorities on this which are referred to below. Counsel further submitted that even if there was a reasonable expectation of profit the expenses were unreasonable and therefore should not be allowed in accordance with section 67 of the Income Tax Act ("Act").

Analysis and Decision

[6]            I am bound by decisions of the Federal Court of Appeal and the following are all decisions of that Court.

[7]            In Tonn v. Her Majesty the Queen, 96 DTC 6001 Robertson, J.A. stated as follows:

ANALYSIS

I am now ready to decide this case. A variety of factors have been proposed over the years by which objective reasonability might be demonstrated in given circumstances. In the original Moldowan decision, these factors were enumerated as follows:

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 capital cost allowance. The list is not intended to be exhaustive.

Another listing of the factors to be assessed was set out in Sipley v. Q.:

The objective test includes an examination of profit and loss experience over past years, also an examination of the operational plan and the background to the implementation of the operational plan including a planned course of action. The test further includes an examination of the time spent in the activity as well as the background of the taxpayer and the education and experience of the taxpayer.

Finally, Landry v. Q. suggests the following items to consider:

Apart from the tests set out by Mr. Justice Dickson, the tests that have been applied in the case law to date in order to determine whether there was a reasonable expectation of profit include the following: the time required to make an activity of this nature profitable, the presence of the necessary ingredients for profits ultimately to be earned, the profit and loss situation for the years subsequent to the years in issue, the number of consecutive years during which losses were incurred, the increase in expenses and decrease in expenses in the course of the relevant periods, the persistence of the factors causing the losses, the absence of planning, and the failure to adjust. Moreover, it is apparent from these decisions that the taxpayer's good faith and reputation, the quality of the results obtained and the time and energy devoted are not in themselves sufficient to turn the activity carried on into a business.

[8]            In Mastri v Her Majesty the Queen, 97 DTC 5420 Robertson, J.A. stated as follows:

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. There are two passages in Tonn which are cited in support of that proposition of law and are worthy of reproduction (supra at 6009 and 6013):

The Moldowan test, therefore is a useful tool by which the tax-inappropriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking. Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

...

... I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer's "business judgment" is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

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.

[9]            In Mohammad v. Her Majesty the Queen, 97 DTC 5503 Robertson, J.A. stated as follows:

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 whose 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.

...

Putting aside the above motivational considerations, it is apparent that this group of taxpayers can have no reasonable expectation of profit provided that the interest component of the rental expenses exceeds anticipated gross rental income. Thus, so long as no payments are made against the principal amount of the purchase-money loans, there can be no reasonable expectation of profit. If, however, the interest component of the rental expenses can somehow be reduced then a positive finding of profitability is easier to sustain, which finding will permit the taxpayer to deduct a portion of the rental loss from employment income....

The above analysis is to the effect 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 monies. As every homeowner soon learns, virtually all of the monthly mortgage payment goes toward the payment of interest during the first five years of a twenty to twenty-five year amortized mortgage loan. It is simply unrealistic to expect the Canadian tax system to subsidize the acquisition of rental properties for indefinite periods. Taxpayers intent on financing the purchase of a rental property to the extent that there can be no profit, notwithstanding full realization of anticipated rental revenue, should not expect favourable tax treatment in the absence of convincing objective evidence of their intention and financial ability to pay down a meaningful portion of the purchase-money indebtedness within a few years of the property's acquisition. If because of the level of financing a property is unable to generate sufficient profits which can be applied against the outstanding indebtedness then the taxpayer must look to other sources of income in order to do so. If a taxpayer's other sources of income, e.g., employment income, are insufficient to permit him or her to pay down purchase-money obligations then the taxpayer may well have to bear the full cost of the rental loss.

[10]          Applying the principles set forth in the above decisions, I am of the opinion that the Appellant did not in the years in question have a reasonable expectation of profit. Admittedly, there were mitigating circumstances which are described above, but, since the losses continued for at least ten years and possibly twelve if 1985 and 1986 were loss years (the Appellant did not file returns in 1985 and 1986 with respect to rental losses) and, moreover, since the rents from the Property in every year were far from even meeting the fixed costs, I must conclude that the Appellant did not have a reasonable expectation of profit.

[11]          Consequently, the appeals are dismissed.

Signed at Ottawa, Canada this 16th day of June 2000.

"T.P. O'Connor"

J.T.C.C.

COURT FILE NO.:                                                 1999-3683(IT)I

STYLE OF CAUSE:                                               Roger A. Julien and The Queen

PLACE OF HEARING:                                         Toronto, Ontario

DATE OF HEARING:                                           June 5, 2000

REASONS FOR JUDGMENT BY:      The Honourable Judge T.P. O'Connor

DATE OF JUDGMENT:                                       June 16, 2000

APPEARANCES:

Agent for the Appellant:                     Bernard Faibish

Counsel for the Respondent:              Adam R. Brebner

COUNSEL OF RECORD:

For the Appellant:                

Name:                               

Firm:                 

For the Respondent:                             Morris Rosenberg

                                                                                Deputy Attorney General of Canada

                                                                                                Ottawa, Canada

1999-3683(IT)I

BETWEEN:

ROGER A. JULIEN,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Appeals heard on June 5, 2000 at Toronto, Ontario, by

the Honourable Judge Terrence P. O'Connor

Appearances

Agent for the Appellant:                                 Bernard Faibish

Counsel for the Respondent:                         Adam R. Brebner

JUDGMENT

          The appeals from the reassessments made under the Income Tax Act for the 1987, 1988, 1989, 1990, 1991 and 1992 taxation years are dismissed in accordance with the attached Reasons for Judgment.

Signed at Ottawa, Canada this 16th day of June, 2000.

"T.P. O'Connor"

J.T.C.C.