Pope v. R, [1996] 1 CTC 2809, 97 DTC 147

O’Connor J.T.C.C.: — These appeals were heard together on common evidence at Sudbury, Ontario on November 7, 1995 pursuant to the General Procedure of this Court. The only person to give oral testimony was Alan

W. Pope. Several exhibits were filed by both parties.

Issue

The only issue in these appeals is whether the Appellants are entitled to certain rental losses claimed in the years 1989, 1990 and 1991 with respect to a residential waterfront property in Naples, Florida (“Property”) acquired on October 30, 1989.

Facts

The basic facts are as follows:

1. In computing income for 1989, 1990 and 1991 the Appellants claimed rental losses in the following amounts, namely

2. The details of the rental losses are set forth in Schedule I of the Reply as follows:

3. The Appellants purchased the Property on October 30, 1989 for $343,000 (U.S.) of which $34,000 (U.S.) was paid cash with the balance of $309,000 (U.S.) being financed by a mortgage with Savings of America for $225,000 (U.S.) and a mortgage on the Appellants’ residence in Timmins, Ontario in an amount expressed in U.S. dollars of $84,000. The interest rate on the $225,000 mortgage was the lender’s normal rate plus 2%. In 1989 this was 10.4% and, because of market conditions, declined to 7% in 1993. The interest rate on the $84,000 (U.S.) dollar equivalent mortgage was 11.75%. This latter mortgage was fully paid in November 1992. The Appellants also spent approximately $10,000 on furniture for the Property.

4. At the time of purchase Mr. Pope was an Ontario lawyer aged 44, Mrs. Pope was a teacher in Timmins, aged 39. Mr. Pope had also been a member of the Ontario Legislature for a term which expired in 1987.

5. Mr. Pope testified in the mid-1980’s he was seeking out investment opportunities and visited various areas of Florida, for example, Delray in 1984, Clearwater and Tarpon Springs in 1985 and Naples in late 1985.

6. Mr. Pope returned to the Naples area in October of 1988 and again in 1989 and examined potential acquisitions with the assistance of three agents. His main agent in the Naples area was Bluebill Properties Inc. (“Bluebill”).

7. Mr. Pope relied on certain representations of this agency and in particular two persons there, namely Gilda Madsen who died prior to the hearing of these appeals and Marie Kay Sanborn. He also reviewed a “board” at the agency showing rentals prices and other details of various properties.

8. Mr. Pope estimated that he could expect rentals from the Property of $2,500 to $4,000 (U.S.) per month for the period from mid- October to mid-May and $1,800 to $2,500 (U.S.) per month for the remainder of the year. This rounded off to approximately $30,000 (U.S.) per annum.

9. The agency showed Mr. Pope several residential units in the area on August 22, 1989 and he actually made an offer on one property on August 23, 1989 but this offer was not accepted.

10. On August 24, 1989 the Agreement of Purchase and Sale for the Property was executed with a closing date of October 30, 1989.

11. The Agreement of Purchase and Sale provided that the Property was being purchased by Mr. Pope “in trust”. He explained that he had intended to purchase the Property through an Ontario numbered company but that this idea was thwarted by the U.S. lender who had a policy of not lending to Canadian companies of this nature.

12. The Property was listed for rental with Bluebill and initially had a tenant on a six-month basis at $2,500 (U.S.) per month for a period commencing December 15, 1989. It was explained that, because of the length of the term of the lease, $2,500 per month seemed a reasonable rate. This initial lease, however, was terminated early, namely on April 15, 1990 after certain negotiations between Mr. Pope and the tenant.

13. Mr. Pope testified that during the three years in question the Popes only used the Property on two occasions in each case for approximately one week.

14. Mr. Pope testified that in addition to rentals he hoped to attract through Bluebill the Appellants also attempted to rent the Property to friends, neighbours and colleagues.

The property was sold in 1994.

16. In cross-examination counsel for the Respondent elicited the following further facts: (a) that the Appellants were not that familiar with rental operations, notwithstanding that Mr. Pope had some familiarity with commercial and rental agreements through his law practice; (b) that the Appellants did not have a business plan nor conduct a market analysis. They simply relied upon a relatively cursory examination of properties and rents in the area and the details on the board in the agency; (c) that, as Mr. Pope stated in his initial testimony, there was a severe decline in market rents commencing late in 1989 or early in 1990 and continuing through the years in question; and (d) that adding the fixed costs such as utilities, taxes, maintenance, interest and insurance the rentals expected could not, in the three years in question, have exceeded the expenses.

Submissions of the Appellants

Mr. Pope submits for the Appellants that they put a total of $43,000 (U.S.) down on the Property, $33,000 for the real estate and $10,000 for furniture. He states further that prior to Revenue Canada’s reassessment disallowing the rental losses, he had actually paid off the mortgage on the Timmins property thus reducing the total interest charges attributable to the Property. Also the interest rate on the $225,000 mortgage had reduced from 10.4% in 1989 to 7% in 1993. He argues further that the fact that he wished to employ a numbered company is a clear indication that he was not intending to claim the rental losses on a personal basis. Further that the unpredictable lower rentals were the main cause for the rental losses and that once he realized the Property was therefore not going to be profitable it was sold in 1994. He argues further that his plan to reduce the interest costs was in fact implemented and there would have been a profit if the rentals had increased as forecasted rather than reducing. He adds that the initial six-month lease and certain other rentals appeared to support his rental projections and had the rental market not collapsed rental profits would have been attainable.

Submissions of the Respondent

Counsel for the Respondent submits that the Appellants had no real rental experience and essentially relied on the agents and casual inquiries. There was no market analysis. The rentals could not, in the years in ques- tion, come anywhere close to matching the expenses not even considering capital cost allowance. He points out there were no projections and that in the relevant years the Property was not properly capitalized. Counsel referred to several authorities and concluded that since there was no reasonable expectation of profit the Appellants should not be allowed their rental losses for the years in question.

Analysis and Decision

Cases dealing with expectation of profit are many and varied. It is clear that each case must be judged on its own facts.

The “reasonable expectation of profit” test originates from the extended definition of “personal or living expenses” found in section 248 of the Income Tax Act:

“personal or living expenses” includes (a) the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit....

This extended definition has been cited by the courts, for more than 40 years, to disallow taxpayers’ losses in a wide range of activities, originally in reliance on what is now paragraph 18(1 )(h) of the Act which provides that no deduction may be made in respect of personal or living expenses of the taxpayer.

In a case not dealing with rental losses but addressing the concept of reasonable expectation of profit, Nichol v. R. (sub nom. Nichol v. Canada), [1993] 2 C.T.C. 2906, 93 D.T.C. 1216 (T.C.C.), Judge Bowman appeared reluctant to use the “reasonable expectation of profit” test where there was no suggestion of personal use or benefit. In the end, he decided he would “deal with the matter as if the Minister’s use of the expression ‘reasonable expectation of profit’ was justified without reference to the definition of ‘personal and living expenses’.” In Nichol, the taxpayer succeeded in deducting losses incurred in starting a semi-professional baseball team in London, Ontario, called the London Royals. Judge Bowman rejected the Minister’s view that the project had no reasonable expectation of profit:

I do not think that it is appropriate for the Minister of National Revenue, who is quite ready to share in the success of an enterprise, to deny the deduction of losses where, with the benefit of hindsight, he considers that the taxpayer should have foreseen that his project would fail. The planning and the projections of the London Royals had too many of the badges of trade and, if I may say so, the indicia of commerciality to be dismissed as a mere hobby or an idealistic labour of love.

In finding for the taxpayer, Judge Bowman suggested that the courts should be wary of making judgments on the basis of retrospective insights:

[The taxpayer] made what might, in retrospect, be seen as an error in judgment but it was a matter of business judgment and it was not one so patently unreasonable as to entitle this Court or the Minister of National Revenue to substitute its or his judgment for it, or penalize him for having made a judgment call that, with the benefit of 20- 20 hindsight, that Monday morning quarterbacks always have, I or the Minister of National Revenue might not make today.

It appears from an extensive review of case law that where a property has been acquired with a reasonable assumption of its being used partly for personal use, a taxpayer with rental losses will normally not succeed in meeting the test of reasonable expectation of profit. The same seems to apply in many cases where taxpayers have capital gains in mind. However, the test has not been so rigidly applied in certain cases lacking either of these elements.

In Bélec v. R. (sub nom. Bélec v. Canada), [1995] 1 C.T.C. 2809, 95 D.T.C. 121 (T.C.C.), the taxpayer acquired a property in 1989 in Ste- Agathe-des-Monts, a vacation community north of Montreal, for a purchase price of $95,000. Mr. Bélec financed $90,000 of the purchase price by way of two mortgages, one on the property and the other on another property he owned. He proceeded to rent the property in question, but suffered losses in 1989 and 1990 of $5,682 and $13,512, respectively. He incurred further loses in 1991 and 1992. The only years under appeal were 1989 and 1990. Judge Bowman noted that the reason for a portion of Mr. Bélec’s losses was a municipal zoning restriction which prevented him from renting out part of the property to a commercial tenant. Nonetheless, it was noted that Mr. Bélec was starting to reduce his losses in 1991 and 1992 as a result, primarily, of a reduction in interest rates on his mortgages. In allowing the appeal, the Court made it clear that there was no question of any personal use of the property by Mr. Bélec. His intention was purely a commercial one. As in Nichol, supra, Judge Bowman indicated that the courts should refrain from second-guessing the business judgment of a taxpayer:

It would be manifestly unjust for the Minister to tax the profits of those who succeed, and refuse to allow the losses of those who do not on the basis that the Minister, with his retrospective view, considers that the taxpayer had no reasonable expectation of profit. it would also be unacceptable to permit the Minister to disallow the deduction of losses at the start of a business on the presumption that it had no reasonable expectation of profit, and, once the business succeeds, tax part of the profits by saying to the taxpayer, in effect: ‘the fact that you lost money when you started the business proves that you had no reasonable expectation of profit, but once you make money, it proves that now you have it’.

In Ahluwalia v. Minister of National Revenue, [1987] 2 C.T.C. 23200, 87 D.T.C. 592 (T.C.C.), a case that dealt with a condominium unit in Florida, the Court made a specific finding of fact that negated any question of personal use. The taxpayer had incurred losses from the property year after year from 1979, the year it was purchased, to at least 1985. The Court noted, however, that rental revenues from the property increased from $3,150 in 1979 to $20,400 in 1986 and that were it not for certain repair costs which could not have been foreseen, the losses in the years 1982 to 1985 (the years immediately subsequent to the years under appeal) would have been substantially smaller or would not have been incurred at all. The Court concluded that the property was acquired and that the expenses of the rental operation were incurred for the purpose of gaining or producing income:

The Respondent’s assumption that there was no reasonable expectation of profit was in my view unfounded. The words ‘reasonable expectation of profit’ mean just what they say. What is required is a reasonable expectation and not a certainty.

Similarly, in Baker v. Minister of National Revenue, [1987] 2 C.T.C. 2271, 87 D.T.C. 566 (T.C.C.), at issue were losses incurred from the rental of a semi-detached house in Florida in each of the three years in which the taxpayer owned the property. The Court accepted evidence to the effect that the property” was not used for the taxpayer’s personal benefit. After citing the Moldowan decision, Moldowan v. R. (sub nom. Moldowan v. The Queen), [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, Chief Judge Couture of this Court made the following observations as to the meaning of the phrase “reasonable expectation of profit” in these circumstances:

...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?

In a number of appeals reported in the jurisprudence the Courts answered no to this question because the venture that was the object of the litigation could not, in the opinion of the Court, achieve that objective for a number of reasons, but mainly because the likelihood of its being financially successful was only a dream in the mind of the operator and rested entirely on his subjective aspirations and hopes which were unrealistic.

In Baker, the Court found that the taxpayer conducted himself like a normal average investor, an investor who was not sophisticated because of lack of professional training, but who nonetheless had a working knowledge of the basic rules of the investment process. The Court concluded that the cause of the failure was simply part of the risk related to the venture.

Based on all of the facts in the present case and accepting fully the credibility of Mr. Pope, I have concluded that the Property was bought as an investment and not for personal use. Nor was there any element of anticipated capital gain alleged or proven. Although the Appellants had no written projection or market analysis Mr. Pope did do a fair amount of investigation as to what rents might be expected. Certain evidence indicates that Marie Kay Sanborn may, to an extent, have duped Mr. Pope into purchasing the Property, because it was later learned that the Property was owned by her separated husband and that she may have had a personal interest in a sale of the Property. This is not critical in itself but is simply another factor to consider.

The Appellants reduced the mortgage interest as planned from 1989 to 1992 thus reducing fixed costs. Notwithstanding this however they could still not show a profit as the market rents in the area had dropped considerably shortly after the purchase of the Property and stayed reduced for a period of time thereafter. Mr. Pope intended to use a numbered company to make the purchase thus indicating no apparent intention to personally recognize rental losses. Furthermore, when, in 1994, the Appellants realized that rental profits were going to be difficult or impossible, they sold the Property.

For the above reasons I am satisfied that, to the extent necessary, the Appellants at the time of purchase reasonably expected that after a reasonable period of time they would realize a profit and consequently the appeals are allowed with costs.

Appeals allowed.