James Menzies and Linda Menzies v. Minister of National Revenue, [1991] 1 CTC 2346, 91 DTC 222

Christie, A.C.J.T.C.:—These appeals which relate to 1981, 1982, 1983 and 1984 were heard on common evidence. The appellants are husband and wife. At the outset of the hearing counsel for the appellants informed the court that the appeals regarding 1981 had been brought in error and were being abandoned. Also that the controversy concerning what is described in the pleadings as the ” Somerset property" is conceded to the respondent.

Disputes remain regarding two residential properties, one of which is on Brunt Road at Nanoose Bay on Vancouver Island (“ Brunt") and the other at 330 Cambridge Street, Nanaimo ( Cambridge"). With respect to Brunt the respondent in reassessing for 1982 disallowed rental losses of $466, an allowable capital loss of $10,000 and a terminal loss from a deemed disposition of $16,484. He also disallowed rental losses pertaining to Cambridge of $13,904, $19,062 and $13,856 for 1982, 1983 and 1984 respectively. Each appellant claimed 50 per cent of the disallowed amounts. Regarding Cambridge the respondent alleges that there were these personal elements of interest expense: 1982—$3,682; 1983—$4,029 and 1984—$3,888.1 [1] Again this was conceded at the commencement of the trial by counsel for the appellants. What remains at issue regarding Cambridge are these rental losses: 1982—$10,222; 1983—$15,033 and 1984— $9,967, and they were disallowed on the ground that there was no reasonable expectation of profit. There is no disagreement about the quantum of the capital, terminal and rental losses.

The difficulties encountered by the appellants that led to this litigation have their origin in these facts: they held two homes encumbered with debt simultaneously at a time of soaring interest rates and in places where the real estate market was severely depressed. Initially each home had been acquired as a residence for them.

James Menzies has been employed as a school teacher in Port Alberni for 24 years. The appellants have been married for 26 years and they have one daughter, Kirstin, who was born in February 1981. Linda Menzies was on leave of absence from her employer MacMillan Bloedel Ltd. from sometime in December 1980 to September 1981. She has been employed as an accountant by that company for almost 15 years and received the designation Certified General Accountant in 1983. James Menzies was on leave of absence from February 1981 to February 1982.

Brunt was acquired in 1979 and the appellants occupied the premises in that year. This came about because Linda Menzies was transferred by MacMillan Bloedel from Port Alberni to Nanaimo. Nanoose Bay is approximately mid-way by road between these cities and each appellant had to drive about 30 miles from there to work. After the birth of Kirstin it was decided to move to Nanaimo to make things easier for Mrs. Menzies when she returned to work in September 1981. In April 1981 Brunt was placed on the market. Initially the appellants tried to sell it themselves, but without success. They planned a tri to Scotland with the baby in May 1981 to visit grandparents. In that month Brunt was listed for sale with Block Brothers Realty. The asking price was $149,000.

Meanwhile they were faced with the decision whether to wait for Brunt to be sold before buying in Nanaimo or proceeding with the acquisition in Nanaimo without the benefit of that sale. It was decided in favour of the latter. The unqualified intention of the appellants was to use the proceeds of the sale of Brunt to reduce the debt incurred for Cambridge. They hoped that there would be an early sale of Brunt.

Cambridge was bought in May 1981. As indicated in the footnote, the price was $155,000. All but $5,000 was borrowed from a bank. Seventy thousand dollars was secured by a mortgage and the $80,000 balance was payable on demand. Before leaving for Scotland, a power of attorney was left with Mrs. Menzies' sister so that whatever documents required signature could be dealt with in the event that an opportunity arose to sell Brunt in their absence. This did not happen. The appellants returned to Vancouver Island in August 1981 to an economic climate in real estate that Mr. Menzies labelled as" beyond belief” and “deplorable”. The rate of interest on mortgages was about 20 per cent, interest on the demand loan stood at 24.5 per cent per annum and the market had collapsed.

On their return the listing of Brunt with Block Brothers had expired and it was not renewed. A" For Sale by Owner" sign was placed on the property albeit with diminished expectations. A decision was then made to seek a tenant. The mortgage was approximately $50,000 and the payments on it in the range of $500 to $550 per month. The appellants discovered what they accepted as a good prospect in the person of Mr. Allan Sibbald. He intended to build a home for himself and his family at Nanoose Bay and wanted to rent there pending its construction. Sibbald was aware, of course, that the appellants wanted very much to sell that home. This undated handwritten agreement was prepared by James Menzies and signed by him and Sibbald:

This is an agreement between Jim Menzies (owner) and Allan Sibbald (rentor) with respect to the house on lot 61, Brunt Rd., Nanoose:

The owner agrees to:

a) give the rentor 60 days notice to vacate the property in the event that it is sold. b) return all rent paid by the rentor if he has to vacate the property before Nov. 30, 1981.

c) give the rentor the months of Sept., Oct. and November 1981 rent free if 60 days notice is given before Nov. 30, 1981.

d) give the rentor $1,000 rebate if notice is given between Nov. 30, 1981 and August 31, 1982.

(All monies to be repaid on completion of house sale)

The rentor agrees to:

a) pay rent of $750 per month, in advance, commencing Sept. 1, 1981.

b) allow the owner to keep the property up for sale privately or with any real estate company.

c) allow the property to be shown to a prospective buyer after having been given reasonable notice.

d) maintain the house and grounds in good condition.

e) pay all B.C. Tel. and B.C. Hydro costs.

f) give the owner 60 days notice of his intention to vacate the premises.

For the four-month period September 1981 to December 31, 1981, this agreement resulted in a profit of $389.36 and in their returns of income for 1981 each appellant included one-half of that amount ($194.68) in calculating their total income. For the four-month period January 1, 1982 to April 30, 1982, there was a loss of $466 and in their returns of income for that year each included a loss of $233 in calculating their total income. The agreement with Sibbald terminated at the end of April 1982 and he vacated the residence.

Reverting to Cambridge, the appellants took up residence there in August 1981. James Menzies said, and this was confirmed by his wife, that the Nanaimo subdivision in which they lived was of "fairly high quality”. But there were problems. By reason of their financial difficulties they did not landscape the lot. Also they had a large German shepherd that had to be constantly chained because there was no fenced yard. The dog got into the garbage of nearby residents and for this and other unspecified conduct he was a source of annoyance to the neighbours, one of whom threatened to shoot the animal. In contrast in both Port Alberni and at Nanoose Bay they had lived in a rural setting with fenced backyards and pleasant surroundings. All of these things culminated in the decision to return to Brunt when Sibbald left and this was done effective May 1, 1982. The eight months that the appellants lived at Cambridge coincide with the same period that Sibbald lived at Brunt. It had also been decided to rent Cambridge.

The appellants made projections regarding Cambridge as a rental property. A document is in evidence in this regard. The projections run from 1982 to 1989. Gross rents were anticipated to increase from $6,300 in 1982 to $12,277 in 1989 or by 95 per cent at a cumulative rate of 10 per cent per year. The annual interest on the demand loan would be reduced from $9,600 in 1982 to zero in 1988 and the interest on the mortgage would be reduced from $7,700 in 1982 to $6,300 in 1989. Other expenses would rise from $1,600 in 1982 to $2,251 in 1989 or 41 per cent. The bottom line was projected losses and profits in these amounts: 1982 ($12,600), 1983 ($10,650), 1984 ($8,401), 1985 ($5,847), 1986 ($2,981), 1987—$204,1988—$2,517 and 1989—$3,726.

An agreement to rent Cambridge was made effective April 30, 1982. The ross rent received for the remaining eight months of that year was $4,650 or $581.25 per month. In 1983 it was $5,962.50 or $496.87 per month and in 1984 rent received was $6,300 or $525 per month. James Menzies was asked about the uneven numbers for 1982 and 1983. He replied that his first tenants were having difficulty paying their rent and he gave them some kind of concession to alleviate their hardship. It will be noted, however, that these figures indicate that the monthly rate was reduced in 1984 from what it had been in 1982.

In 1982 interest on the Cambridge debt as set out in the appellants' returns was $17,371.91. If the previously mentioned personal element of $3,682 is deducted the amount of interest remaining and attributable to the business of renting Cambridge was $13,689.91. The same figures for 1983 are $19,511.41, $4,029 and $15,482.41 and for 1984 they are $18,151.98, $3,888 and $14,263.98.

On June 29, 1983, the Port Alberni Branch of the Canadian Imperial Bank of Commerce sent this letter to the appellants:

In response to your visit to our office in May, we advise that your request for a lower interest rate has been given full consideration, but has been declined. The Bank takes the position that 2% above Prime is a fair and equitable rate for the type of loan you were granted.

The Bank has renewed your loan for a further period ending September 30th on the following conditions:

1) Both properties are to be immediately listed for sale, at a price to effect a quick sale and in line with a current realtor's letter of opinion and/or the 1983 B.C. Assessment Authority.

2) If the loan is not substantially reduced or liquidated by expiry date, the Bank

will expect a more realistic repayment schedule to be placed into effect.

We trust that our letter has clarified our position.

James Menzies replied as follows on July 4, 1983:

I am in receipt of your letter of June 29, 1983, regarding my $80,000 demand loan. As a good customer of your bank for the past twelve years or so, I find the tone of the letter rather disconcerting. In particular the condition for extension of the loan which refers to the immediate listing of both properties "to effect a quick sale” seems to be very insensitive to the circumstances of my present situation.

This pressure from your institution comes at a time when it is certainly not in my best interests to sell, nor at a time when I have any particular financial urgency to sell. Consequently, I am asking you to put into place, immediately, a repayment schedule that is mutually acceptable, and to leave the sale of the properties to my discretion. Since I have assets other than the two properties under consideration, it may be advisable for me to take alternative action.

I can assure you that it is my intention to liquidate the loan as soon as possible, and a strategy in the interests of us both will expedite this.

In October 1986, Cambridge was placed on the market and title was issued to the new owner on December 1, 1986. It sold for $85,000 or 55 per cent of what the appellants paid for it in May 1981. Renting it was simply not working out as a business matter. Market conditions precluded increases in rents. The appellants’ tenants had given notice that they were leaving at the end of 1986. Further the whole matter was having an adverse effect on Mrs. Menzies' health. The inference that I draw from the evidence is that in deciding to rent Cambridge the appellants hoped to reduce the capital loss that would be sustained on its disposition. This could have succeeded if the market turned in the appellants’ favour, but it did not and after over four years it was decided this tactic was not worth the struggle.

The pivotal statutory provisions regarding the claimed capital loss on the Brunt Road property are in paragraph 45(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). What is relevant therein for these appeals provides that for the purposes of the subdivision of the Act relating to taxable capital gains and allowable capital losses this rule applies:

. . . where a taxpayer having acquired property for some other purpose, has commenced at a later time to use it for the purpose of gaining or producing income therefrom, or for the purpose of gaining or producing income from a business, he shall be deemed to have disposed of it at that later time for proceeds equal to its fair market value at that later time, and immediately thereafter reacquired it at a cost equal to that fair market value.

The appellants say that when they acquired Brunt it was as a principal residence and when it was occupied by Sibbald under the agreement its use was converted to the purpose of gaining or producing income from. the business of renting it. In their returns of income for 1982 they claimed an allowable capital loss of $10,000 ($5,000 each) in respect of the land. The question to be decided in this regard is: did such a conversion occur? I consider that the proper conclusion to be drawn from the evidence is no.

In order for a taxpayer to successfully allege that real estate acquired by him as a principal residence has commenced later to be used for the purpose of gaining or producing income from a rental business, he must establish more than an agreement that, subject to contingencies regarding the anticipated sale of the property, may produce some income. The overriding intention must exist to use the property as an asset in a rental business and an arrangement that is essentially designed to temporarily defray costs pending the sale of the property and facilitate that sale will not suffice.

The whole tenor of the agreement signed by James Menzies and Allan Sibbald points to an arrangement of that kind. Both parties knew that Sibbald’s occupancy would only be for the short term pending the building of his new home. Each of the four undertakings given by James Menzies relates to the sale of the property. If by reason of a sale Sibbald had to vacate before November 30, 1981, all of the rent paid for September, October and November was refundable and, of course, no income was even possible under that contingency. Under the other contingency whereby if notice to vacate were given to Sibbald before November 30, 1981, these would be among the possible results: there could have been one month's rent payable for occupancy for four months or two months' rent payable for occupancy for five months.

Two of the things agreed to by Sibbald relate directly to the intended sale of the property. I refer to his allowing the appellants to endeavour to sell it either privately or through a real estate company and to allow the property to be shown to prospective buyers. Having someone like Sibbald occupying the property at Nanoose Bay with these assurances coupled with his undertaking to maintain the house and grounds in good condition might well contribute to effecting a sale.

There is authority for the proposition that if there is a statutory requirement that property be acquired for the purpose of gaining or producing income it will not be met if there is in fact rental income from the property, but securing that income was not the overriding purpose of the acquisition. By the same token if there is a statutory requirement that the use of a property be changed to use for the purpose of gaining or producing income from a business it will not have been complied with if what occurred in respect of the property was an arrangement the basic purpose of which was short term use of it to defray expenses pending its sale and to assist that sale.

In Ben's Ltd. v. M.N.R., [1955] C.T.C. 249; 55 D.T.C. 1152 (Ex. Ct.), paragraph 1102(1)(c) of the Income Tax Regulations was considered. The effect of it was that property in"respect of which capital cost allowance is claimed must have been acquired for the purpose of earning come. It provided:

1102. (1) The classes of property described in this Part and in Schedule B to these Regulations shall be deemed not to include property

(c) that was not acquired by the taxpayer for the purpose of gaining or producing income.

The appellant owned and operated a bakery in Halifax. In January 1952 it purchased three adjoining properties on each of which there was a residence. The three properties were acquired with the intention that the residences would be removed and the land used for an extension to the bakery. This could not be proceeded with immediately because the properties were zoned for residential use and in order to change this for commercial or business purposes re-zoning was necessary. This was not achieved until September 20, 1952. The appellant had secured vacant possession of two of the dwellings at the time of purchase. An intended use of them as storage space for the business was alleged. Rents were received in respect of the third property under leases that expired on May 1, 1952. All three buildings were sold early in June and removed from the land. Shortly after September 20 a contract was awarded for the construction of the extension to the bakery.

In its return of income for 1952 the appellant sought to deduct capital cost allowance with reference to the buildings. In reassessing this was disallowed by the Minister. The appeal from his decision was dismissed. Mr. Justice Cameron said at page 255 (D.T.C. 1155):

On the evidence as a whole, I am satisfied that the sole purpose in making the purchase was to acquire a site for the extension of the factory. There never was any intention to acquire the frame houses for gaining or producing income; the sole intention in regard to the houses was to have them torn down and removed at the earliest possible moment, and that purpose was carried out. The mere fact that certain amounts of rental were obtained from one is attributable to the existing leases and does not affect in any way the real purpose of acquisition. Section 1102(a)(c) (sic) of the Regulations therefore bars the frame houses, under the circumstances, from being property which was subject to capital cost allowance. The appeal on this point is therefore disallowed.

See also: J. Clark & Son Ltd. v. M.N.R. (1957), 18 Tax A.B.C. 196; 57 D.T.C. 567 (T.A.B.); Merrett v. M.N.R. (1958), 18 Tax A.B.C. 344; 58 D.T.C. 88 (T.A.B.) and Phillips v. M.N.R. (1961), 28 Tax A.B.C. 81; 61 D.T.C. 677 (T.A.B.).

With respect to the terminal loss of $16,484, reference is made to subsection 20(16) of the Act. It reads:

20. (16) Notwithstanding paragraphs 18(1)(a), (b) and (h), where at the end of a taxation year,

(a) the aggregate of all amounts determined under subparagraphs 13(21)(f)(i) to (ii.1) in respect of depreciable property of a particular prescribed class of a taxpayer exceeds the aggregate of all amounts determined under subparagraphs 13(21)(f)(iii) to (viii) in respect of depreciable property of that class of the taxpayer, and

(b) the taxpayer no longer owns any property of that class,

in computing the taxpayer's income for the year

(c) there shall be deducted the amount of the excess determined under paragraph (a), and

(d) no amount shall be deducted for the year under paragraph (1)(a) in respect of property of that class,

and the amount of the excess determined under paragraph (a) shall be deemed to have been deducted under paragraph (1)(a) in computing the taxpayer's income for the year from a business or property.

In order for a terminal loss to have been created under this subsection the dwelling house on the Brunt Road lot must have been depreciable property in 1982. The finding that it was not converted from use as a residence to use for the purpose of gaining or producing income from a rental business rules this out. It also disposes of the issue about the deductibility of the rental losses of $466 in favour of the respondent.

With respect to the rental losses regarding Cambridge, the sole question to be answered is the one that so often arises in disputes between the revenue authorities and taxpayers regarding the deductibility of losses of that kind, namely: was there a reasonable expectation of profit from renting the property that relates to the losses claimed as deductions? The appellants can succeed only if the answer is yes. It is not necessary that the reasonable expectation be that of the existence of actual profit in the year or years under review. The test will be met if the expectation exists for a period beyond that if, objectively examined, the taxpayer has organized an undertaking that having regard to such things as the relationship between investment and debt, projected income and expenses is commercially feasible. In Baker v. M.N.R., [1987] 2 C.T.C. 2271; 87 D.T.C. 566, Chief Judge Couture said at 2273-74 (D.T.C. 568):

Dickson, J. (as he then was) in William Moldowan v. The Queen, [1977] C.T.C. 310; 77 D.T.C. 5213, said at 313 (D.T.C. 5215):

There is a vast case literature on what reasonable expectation of profit means and it is by no means consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all the facts.

I understand this to mean that a reasonable expectation of profit exists where given all the facts pertinent to a venture it could, within a realistic time (the period will vary depending on the nature of the operation), yield a profit barring abnormal circumstances. In other words, is the venture as structured and normally operated capable of generating a profit?

I cannot agree that there was a reasonable expectation of profit from renting Cambridge. It was purchased in May 1981. At that time the ratio of debt to investment was 150,000 to 5,000. Although it was then hoped that this debt would be significantly reduced by the sale of Brunt that had not happened by May 1982 when Cambridge was rented and it would not happen after that date because the appellants again took up residence at Brunt. Under depressed market conditions they projected rent increases of 94 per cent over the period 1982 to 1989. In fact they found it impossible to raise the rent. They foresaw losses for the five-year period from 1982 to 1986 and profit after that. In 1986 they concluded it was not practical to go on renting and sold the property. Finally I underscore that in 1982 the gross rental income for Cambridge was only 34 per cent of interest expense after deducting therefrom the interest element attributable to the appellants personally. The percentages similarly arrived at for 1983 and 1984 are 39 and 44.

For all of these reasons these appeals must be dismissed.

Appeals dismissed.