Frank Foldy v. Minister of National Revenue and Linda Jarian v. Minister of National Revenue, [1991] 1 CTC 2175, 91 DTC 361

Sarchuk, T.CJ.:—Frank Foldy and Linda Jarian have appealed from reassessments with respect to their 1985, 1986 and 1987 taxation years. By consent of all parties the appeals were heard on common evidence.

The appellants take issue with the respondent's disallowance in full of certain rental income losses claimed by them in those taxation years. In so assessing the respondent acted on the basis that the deduction of the claimed expenses is prohibited by paragraph 18(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") as they were not made or incurred for the purpose of gaining or producing income from business or property.

Evidence was given on behalf of the appellants by Mr. Foldy and the appellants’ accountant, Mr. Ronald M. Blair.

The property in question is located in a new development in Port Charlotte, Florida. It was purchased by the appellants in 1980 at a price of $53,000 (U.S.) The purchase was financed by way of $20,000 in cash with the balance secured by way of a mortgage. The property included a two-bedroom single family house with a swimming pool and was located some four miles from the Gulf of Mexico.

The appellants assert that the property was never intended for personal use but was at all times an investment. The purchase followed Foldy's attendance at three or four seminars, as they are euphemistically described, organized by the builders and merchandisers of the development. The information imparted to him at the seminars projected a rosy rental picture including probable high season occupancy of 20 weeks or more. Foldy says he made further inquiries as to the rental market and made some other general investigations of his own before they decided to purchase. He also consulted Blair. His association with Blair arises out of the fact that he is a pilot and that on a number of occasions he has flown Blair to other areas in Florida in the course of Blair's business, part of which revolved around the sale of real estate in Florida. This discussion apparently took place shortly after his decision to buy and consisted of a brief review of the acquisition. Foldy asserts at this stage that he prepared financial projections (which are no longer available) while Blair's recollection is that the discussion was quite perfunctory. He said that it consisted of no more than calculating the projected weekly rental figures provided by the developer over the projected high season rental of five months (assuming full occupancy) and adding thereto a lesser amount for slow season rental. Using this result he opined that it seemed to be an excellent investment.

Although the purchase took place in 1980 the property was not completed and furnished to the appellants' satisfaction until 1981. When the appellants were ready to rent, they discussed that they were only able to obtain tenants for three to five weeks. Foldy's explanation was that the rental market took a sudden fall. As a result they chose not to rent the property at all.

In the autumn of 1984 the appellants returned the property to the rental market. At this time, however, they chose not to engage a Florida rental manager. Rather, they proposed to do it themselves by way of advertisements in newspapers and by word of mouth. They set a rental of $500 (U.S.) per week for the high season. They also insisted on screening their tenants personally (even to the extent of visiting their homes) to assure themselves of their qualifications as tenants. Foldy said that he would not have rented otherwise and agreed that this approach would obviously reduce the size of the tenant pool. A conscious decision was also taken not to rent during the summer because the cost of maintaining the property was likely to exceed any potential rental income. I should note that I found much of Foldy's evidence regarding the "cost analysis” that he made to reach the foregoing decisions less than informative.

The property was rented on this basis for the high seasons 1984-1985, 1985-1986 and 1986-1987. Foldy’s testimony as to the level of occupancy, the rentals sought and the rental produced was quite imprecise and somewhat inconsistent with the rental income reported in his returns. In their returns of income for the 1985 taxation year the appellants Foldy and Jarian claimed rental losses of $1,907.10 and $4,449.90 respectively with respect to the property, computed as follows:

In their returns of income for the 1986 taxation year the appellants Foldy and Jarian claimed rental losses of $1,543.25and $4,629.75 respectively with respect to the property, computed as follows:

In their returns of income for the 1987 taxation year the appellants Foldy and Jarian each claimed rental losses of $2,802.50 with respect to the property, computed as follows:

As to the unequal allocation of losses between the appellants in taxation years 1985 and 1986 the evidence was both inconsistent and unclear. Foldy implied that the allocation was done by the accountant. Blair said that the amounts were allocated as shown in the returns on the instructions of the appellants. Nothing of import hinges on the allocation per se, however the appellant's inability to be relatively precise in his testimony on this, and on other matters reflects poorly on his credibility.

At some point of time in 1986 the appellants retained a Florida property manager, ostensibly to find a long-term tenant for the property. In the latter part of 1987 they entered into a two-year lease (not produced). According to Foldy the major feature of this arrangement was that certain expenses would be paid by the tenant and would be deducted from his gross rents. These expenses included utilities, maintenance and a share of the property taxes. Neither Foldy nor Blair shed much light on the exact terms of the agreement and it is not certain whether the gross rents reported in the appellants' 1987 taxation year reflected this tenancy since there is no reference to the allocation of expenses in the accompanying statement of rental operations.

Foldy testified that the venture earned a small profit in both 1988 and 1989. No return has been filed for the 1989 taxation year. For 1988 he produced the statement of rental income and expenses which had been filed with his income tax return for that year. It shows a purported net profit of $625. However the rental income and expenses set out therein were the subject of conflicting evidence given by Foldy and Blair. With respect to this statement the best that can be said, and I am being charitable, is that it is questionable. In my view it has no probative value as far as the appellants are concerned, and given the timing of its preparation, that is following a Revenue Canada audit of the previous years, negatively impacts on the weight to be given to Foldy’s assertions of profitability in 1988 and 1989.

Counsel for the appellants argued that the appeal should be allowed on the basis that the appellants had established that in the taxation years in issue they had a reasonable expectation of profit from renting the property. He submitted that at the time of purchase they had reason to believe that the investment was viable. The failure of the project was the result of the fact that the rental projections did not materialize and that failure could not be imputed to the appellants. He relied on the decisions of Baker v. M.N.R., [1987] 2 C.T.C. 2271; 87 D.T.C. 566, O’Reilly v. M.N.R., [1969] Tax A.B.C. 1079; 69 D.T.C. 751, Girgis v. M.N.R., [1984] C.T.C. 3005; 84 D.T.C. 1794 and Paikin v. M.N.R., [1987] 1 C.T.C. 2041; 87 D.T.C. 6.

With respect to the decisions cited let me say at the outset that each was determined on the basis of its own peculiar facts. That is not to say that they are irrelevant and should be disregarded, but in appeals involving the acquisition of property and the intentions of the purchasers at the relevant time, what is of primary importance is the weight to be given to the testimony of the appellants tested in the context of all of the other facts in evidence.

I have concluded that the appeals cannot succeed. The simple question is whether the losses claimed can be characterized as expenses within the meaning of paragraph 18(1)(a) of the Act. That paragraph provides an exemption to the general rule against deductions from the income of a taxpayer with respect to an outlay or expense to the extent that it was made or incurred for the purpose of gaining or producing income from the property. This means that for an expense to be deductible there must be a source of income. In order to have such a source the taxpayer must have a profit or a reasonable expectation of profit (Moldowan v. The Queen, [1978] 1 S.C.R. 480; [1977] C.T.C. 310; 77 D.T.C. 5213). With respect to the meaning of" reasonable expectation of profit" Dickson, J. said at pages 313-14 (D.T.C. 5215) of Moldowan:

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.

The onus is on the appellants to demonstrate the existence thereof at the time of purchase. In my view they have failed to do so. The proof necessary to establish the existence of a reasonable expectation of profit from an enterprise goes well beyond the declared intention of a taxpayer, even given under oath. Such a statement, of course, cannot be ignored but all the facts surrounding the acquisition and the operation of the property, its earning potential and its carrying charges, must be such as to satisfy an objective observer that a profit can reasonably be expected to arise from its rental alone (Scott v. M.N.R.,

[1984] C.T.C. 3040; 85 D.T.C. 1). The evidence before me does not support the appellants’ assertions. Foldy's testimony leads to an inference that in the years in issue they could not normally have expected to rent the property beyond the high season and I am satisfied that both were aware that it would be most exceptional if any landlord in such a market could reasonably expect 100 per cent occupancy. Any projections made by Foldy (if indeed they were) were clearly optimistic and not the result of any business-like considerations. It is clear from the evidence of both Foldy and Blair that there was no specific analysis of the acquisition. The appellants made no market evaluation of any significance independent of the material provided by the vendors and no rental expense analysis was made other than that based on the information they provided. Furthermore, while Foldy testified that in his opinion there was an unexpected plunge in the rental market, there is no direct evidence as to the nature of the market in the Port Charlotte area; nor as to any sudden change in that market or when it occurred. As Strayer, J. stated in Meech v. The Queen, [1987] 1 C.T.C. 421; 87 D.T.C. 5251 at 423 (D.T.C. 5253):

While I do not believe a taxpayer has to prove that he took all prudent steps to satisfy himself that a profit could reasonably be expected when making the original investment, if by an objective test such an expectation would have been «reasonable, such evidence would strengthen his contention that he had good reason to expect a profit within a reasonable time. The taxpayer here has not satisfied me that he took such steps.

I therefore find that the expenses in issue were not incurred for the purpose of gaining or producing income but were personal living expenses of the appellants within the meaning of the Income Tax Act.

The appeals are dismissed.

Appeals dismissed.