Lawrence S. Paikin v. Minister of National Revenue, [1987] 1 CTC 2041, 87 DTC 6

Kempo, T.C.J.:—This appeal is from reassessment for the 1981 taxation year of the appellant wherein the respondent disallowed losses exceeding the gross rentals in respect of a condominium described as Apartment 11G, 5750 Collins Avenue, Miami Beach, Florida, U.S.A. (the “property”). The appellant alleges the reassessment is in error in that the property was purchased for the purpose of investment, that is for the purpose of earning income, and that all expenses should be allowed.

The Minister, in disallowing the deduction, relied upon paragraphs 18(1)(a), 18(1)(h) and subsection 248(1) "personal or living expenses" paragraph (a) of the Income Tax Act (the "Act") which are as follows:

Sec. 18. General limitations.

(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation.—an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(h) Personal or living expenses.—personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on his business.

Sec. 248. Definitions.

(1) In this Act,

Personal or living expenses.—“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.

As in most situations of this kind, the facts of each case are of key significance in arriving at a final determination of the issues.

The evidence of the appellant was that he was an officer, general manager and 50 per cent owner of a highly successful Ontario steel company that was engaged in the business of steel reinforcement, a product used in high-rise structures of concrete construction. Many of his clientele had constructed real estate developments in places like Carolina, Arizona and Florida and, knowing of the booming economic times in those areas during the latter part of the 1970s, he made it known that he was interested in taking part in real estate ventures for investment purposes. The appellant had investments in securities as well as a 50 per cent interest in a commercial rental property in Ontario.

In 1980 the appellant’s sister, a licensed stockbroker working and living in New York, called and told him of an opportunity for both of them to jointly acquire, for real estate investment, their mother's apartment which was in a structure undergoing conversion from rental to that of a condominium. This was at a time when Florida was enjoying a booming real estate market with insufficient residential condominiums then on hand to meet an unprecedented demand. Apparently they could not be built fast enough; prices were escalating rapidly.

Of equal and significant importance to them was the fact that their mother was to remain in possession of the property as a full-time tenant paying rental at fair market value. The reasons for this being commercially advantageous were numerous. Time and management fees would be avoided, the property would be well cared for, the annual municipal taxes would be discounted by 22 per cent, the asking purchase price would be reduced by ten per cent and receipt of an annual fair market rental would be ensured on a long-term basis. Resale was not contemplated even if the mother moved out.

Prior to the purchase, investment advice was sought and an extensive investigation was conducted by the appellant with respect to the location, condition and value of the project. All matters relating to mortgage arrangements and operating costs were examined and analyzed. A copy of a detailed prospectus was obtained from the developer and the appellant used the proposals for maintenance costs that the developer had provided. Because lawful conversion was conditional on extensive capital repairs or replacements having been affected by the developer, reasonable and stable maintenance costs were anticipated. The appellant and his sister were able to obtain a 30-year fixed-rate mortgage on the property. It was open as to prepayment and its 13 /2 per cent interest rate was less than the going Canadian rate at that time.

The appellant described his mother as being widowed but entirely financially independent. She was in no need of financial assistance. Her ill-health required visitations. No vacations were either had or were intended to be taken in Florida. He categorically denied that the property had been acquired for the purpose of housing or maintaining his mother. To him having his mother there was, in all respects, benefiting the investment and its commercial profitability.

The purchase price of the property was $135,000 (U.S.) of which $108,000 (U.S.) was financed by way of bank mortgage given by the appellant and his sister. An initial monthly shortfall amounting to $545 (U.S.) each was anticipated. This was calculated as the difference between receipt of the current monthly rental income of $650 (being its then fair market value) and the $1,740 outlay for mortgage principal and interest, property taxes and condominium fees.

Positive cash flow was expected to occur in ten years without paying down the mortgage. This projection was based on an anticipated annual ten per cent increase in rental income and an annual five per cent increase in expenses. Long-term holding was the plan with the view to receiving rental income increases corresponding with the capital appreciation of the underlying investment asset.

The open and fixed rate mortgage, obtained on the advice of his advisors, was to enable the appellant to pay it down when funds were available and if it made commercial or business sense to do so. With respect to the latter, the appellant explained that no specific time frame had been contemplated but that when he had funds (various sources were described) he planned to use them to pay down the mortgage if the then current interest rates dictated this as the better business tactic. This in fact happened in 1984 when, having received funds from the sale of his 50 per cent interest in his commercial property, the appellant then paid his half of the mortgage. Apparently any other investment of these funds would have attracted a lesser interest return than what was being paid on the mortgage.

In his financial projections the appellant disregarded depreciation or capital cost allowance matters in arriving at what he considered to be the profitability of his investment. To him profitability occurred with or could be equated to a time of positive cash flow. And when this happened it was always his intention to claim capital cost allowance and thereby reduce the taxable income for tax purposes. He viewed depreciation allowances as an advantage with respect to fiscal profitability and of minimal applicability with respect to investment profitability. This view was described as an ordinary commercial principle by the evidence of a chartered accountant and experienced tax advisor, Mr. David Jones, who had often advised his clients in real estate investments as well as being fully familiar with this kind of activity through investments on his own account.

By agreement at the conclusion of the hearing, a three-page document of projected income and expenses, including capital cost allowance, has been subsequently filed by counsel for the appellant. It is to be considered as an agreed statement of facts as outlined in a covering letter dated March 25, 1986. Both counsel admit the accuracy of the calculations with the caveat that the respondent does not accept the underlying assumptions that rental income would increase at the rate of ten per cent per annum and that rental expenses would increase at the rate of five per cent per annum and counsel for the appellant does not admit that capital cost allowance should be taken into account in determining whether the appellant had a reasonable expectation of profit in this venture.

Assuming that the mortgage was not paid off, the calculations in Schedule A of these projections indicate a break-even point occurring in the tenth year of holding and a net rental income after charging capital cost allowance occurring in the thirteenth year of holding. Assuming full payment of the mortgage in April of 1984, (as it had been) the calculations in Schedule B of these projections indicate net rental income occurring in the fourth year of holding and net rental income after charging capital cost allowance occurring in the fifth year of holding. And with prepayment of the mortgage, the projection indicates that the appellant would not have recouped his losses from the initial years of operation until 1990. Capital cost allowance was premised on 75 per cent of the purchase price being allocated to the building, the balance being for the land.

While the various schedules of income/expense projections that have been filed in these proceedings give some insight into the matter, the appellant's viva voce evidence, in the main, was that his expectations were made during the economic conditions of the time under which he and his advisors were confident of investment profitability within a reasonable time premised on fixed and stable operating costs, a guaranteed long-term tenant paying fair market value rental during a time of intensive capital appreciation which in turn would command a corresponding higher rental value.

As it turned out the market suddenly and unpredictably collapsed and the appellant’s losses were increased through unpredictable events (as explained in the evidence) over which he had no control.

The appellant conceded that, using his own projections, only a very modest or minimal overall return in this investment could be expected but stressed that significant capital appreciation occurring over the long-term was anticipated when considering its capability of producing income. A business judgment had been made during the prevailing economic times and expectations following research, analysis and advice having firstly been obtained. He stressed that there was nothing unusual or unique in his approach or judgment as many other business investors were doing the same thing.

The evidence of Mr. David Jones, the chartered accountant and tax advisor previously referred to, was that it was his experience that when dealing with this kind of real estate investment purely from its investment perspective, depreciation is rarely taken into account in the determination of its profitability but that it is material only in its fiscal implications. And having considered the many positive features of the overall plan, he felt it was a good investment based on reasonable assumptions, even with a long-term being projected. Two components were stated to be material; one was the investment's ability to generate income and the other was the reasonably anticipated capital appreciation of the asset itself. And in the business world, the latter usually determines the former. It was his experience that knowledgeable real estate investors rarely use the word "profit” but are more concerned with matters of positive cash flow and the minimizing of their operating shortfalls.

Following the hearing counsel for each party filed extensive written submissions.

Analysis

Having regard to the whole of the evidence, and notwithstanding counsel's innovative and persuasive analysis and submissions, I do not agree with the following positions taken on behalf of the respondent that the appellant’s appeal must fail because (a) the expenses related to maintenance of property for his mother's use or benefit, and that in any event (b) the income source was from property and not from the maintenance of property in connection with a business as is called for in subsection 248(1) "personal or living expenses”, supra, that (c) there was no reasonable expectation of profit, and that (d) the subject loss was incurred prior to the commencement of a business and is therefore not deductible.

The evidence establishes that the property was purchased, intended and operated not for the personal use or benefit of the appellant or his mother but as a revenue-producing investment. As counsel submits, the benefit attributable to the appellant’s investment from his mother's occupancy eclipsed any personal benefit derived by her from her use or occupancy and therefore, in this sense, the property was not being maintained for the use or benefit of the appellant’s mother. Indeed, she neither required nor received any uniquely personal use or benefit therefrom but rather had agreed and was expected to pay rental at fair market value while in possession. Additionally her occupancy brought with it a reduction or discount in both the purchase price and municipal taxes, an assured annual rental income along with relieving the appellant of the time and costs relative to management. If she did vacate, the plan was not to sell but to continue renting the unit. In my view there is little difficulty in finding that paragraph 18(1)(h) of the Act is not applicable. The property was acquired and maintained in a commercial manner for a commercial purpose notwithstanding the spectre raised by the respondent attributable to the mother's occupancy.

As to the business aspect of this case, the evidence establishes a thoughtful, well researched business approach having been brought by the appellant to this venture from its very inception. He had done all that a reasonably prudent successful businessman would do. It was his plan from the outset to prepay the mortgage when funds became available and the fact that he did so at the earliest possible time is corroborative of his stated original intent to retain the property for long-term rental income. I do not think it would be useful to enter upon any speculation involving a premise that under other circumstances the appellant, to gain a higher rate of interest, might have redirected the funds elsewhere. The point is he did not. He continued his initial commitment to this investment as a long-term venture by a large infusion of capital in 1984.

The respondent has questioned the reasonableness of the appellant’s expectation of profit in the 1981 taxation year for the reasons that without actual payment-out of the mortgage it was projected by the appellant to take ten or eleven years for positive cash flow, and even longer if depreciation allowances were taken into account; and further that the capital invest- ment in the property was unlikely to be recovered out of the profits over a reasonable period of time. Accordingly counsel for the respondent submits that the venture, as capitalized in 1981, could not yield a profit in a reasonable time and that the loss incurred prior to the mortgage payout was a loss suffered prior to the commencement of a business and for that reason it is not deductible.

The bulk of the authorities relied upon by counsel for the respondent in support of his aforenoted positions involve farming operations. For the reason that they are factually distinguishable, they carry only persuasive authority. Each case should be viewed on its particular circumstances. Particular reliance was placed on the principle found at 314 (D.T.C. 5215) in Moldowan v. The Queen, [1979] C.T.C. 310; 77 D.T.C. 5213 (S.C.C.) that consideration is to be given to the “capability of the venture as capitalized to show a profit after charging capital cost allowance”. However this consideration is not, as I see it, cast in stone such that it alone is to be determinative. It is simply one of the considerations to be taken into account along with equal and due regard being given to the nature and extent of the undertaking, the taxpayer's training and his or her intended course of action. No exhaustive list was intended, vide Moldowan at (D.T.C. 5215), nor prescribed, vide Hadley v. The Queen, [1985] 1 C.T.C. 62 at 67; 85 D.T.C. 5058 at 5064.

Cartwright, J. in Dominion Taxicab Association v. M.N.R., [1954] C.T.C. 34 at 37; 54 D.T.C. 1020 at 1021 (S.C.C.) noted that:

The expression “profit” is not defined in the Act. It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such principles.

The comments of Mahoney, J. in The Queen v. Matthews, [1974] C.T.C. 230 at 236; 74 D.T.C. 6193 at 6197 (F.C.T.D.) are adaptable to the situation at bar.

The conduct of a business whose profits are not expected to reimburse the capital cost of an asset that is not subject to waste or depreciation in the process of production nor to obsolescence by the passage of time or the development of technology does not violate ordinary commercial principles so as to lead to the conclusion that the business is not being carried on for profit or with a reasonable expectation thereof.

At the time the appellant entered into the subject venture it would not be unreasonable for him to have down-played factors of depreciation or recovery of capital cost allowance in determining his expectation of profit for the reason that the value of the asset was, realistically, expected to increase rather than decrease and because the structure housing the unit had been upgraded, was in good condition with reasonable fees being paid for its ongoing maintenance.

The appellant does not have to show expectation of reasonable profit, vide Matthews at 236 (D.T.C. 6197), but rather that, having regard to the approach and the venture as a whole, the expectation of profit was reasonable and would occur within a reasonable time. The mortgage pay-off was not an afterthought in this case. I accept that it was in fact made as part of the appellant's initial plan whereby the time at which positive cash-flow would occur should be markedly accelerated.

The approach taken by Addy, J. in McLaws v. The Queen, [1976] C.T.C. 15; 76 D.T.C. 6005 (F.C.T.D.) at 18 (D.T.C. 6008) is transposable to the situation of this appellant. He notes that

[t]he mere fact that the horse-racing enterprise was not an immediately profitable one is not too important if there is a prospect of profits being produced eventually as the operation improves. The question is whether there is a reasonable expectation of profits and the expectation need not relate to the immediate future.

and at 20 (D.T.C. 6009) he said:

As to the reasonableness, to hold that the expectation of future profits combined with the possibility of large purses, from what the partners must consider to be relatively small expenditures, does not constitute a reasonable expectation, would involve substituting my own business judgment to that of four extremely successful businessmen, without any real evidence to justify such a finding.

The answer to the respondent's submission that no business or commer- ciality existed prior to prepayment of the mortgage is at least twofold. Firstly there was a reasonable expectation of profit at the outset. Of greater significance or merit, however, is the compelling and highly persuasive reasoning and submission by counsel for the appellant that:

The Court may consider the investment of additional capital in subsequent years where the nature of the business carried on in the years in question is the same as the business carried on after the investment of additional capital and the capital investment is part of a well orchestrated plan for profit making which was followed from the outset.

Decision

For all of the aforementioned reasons, the appellant has successfully rebutted the respondent's essential assessing positions as pleaded in paragraph 5 of his reply to notice of appeal that:

the Appellant in renting the Unit was not engaged in an activity carried on for profit or with a reasonable expectation of profit [Paragraph 5(g)];

the expenses which created the losses from the rental of the Unit, were not incurred for the purpose of gaining or producing income but were personal and living expenses of the Appellant [paragraph 5(h)]; and that

the activity, of purchasing and renting the Unit, as capitalized was not an activity carried on for profit or with a reasonable expectation of profit [paragraph 5(i)].

The appeal is allowed, with costs, and the matter referred back to the respondent for reconsideration and reassessment on the basis that in computing the appellant’s income for the 1981 taxation year a deduction be allowed for the loss arising from his rental of the Florida condominium unit.

Appeal allowed.