Steven Chan v. Minister of National Revenue, [1980] CTC 2261, 80 DTC 1239

D E Taylor:—This is an appeal heard in Victoria, British Columbia, on January 24, 1980, against income tax assessments for the years 1975 and 1976 in which the Minister of National Revenue allowed no capital cost allowance (cca) with respect to a parcel of real property owned by the appellant, and disallowed a deduction claimed for interest. In assessing the appellant, the respondent relied, inter alia, upon section 20 of the Income Tax Act, SC 1970-71-72, c 63 as amended, upon section 1100 of the Income Tax Regulations and upon the classes of property included in Schedule B thereto.

Background

On December 12, 1975, the appellant purchased for $185,490 the Waldorf Trailer Park, consisting of land and buildings (the property), which he continued to operate as a motel and trailer park. In filing his 1975 income tax return, the appellant did not take any cca, but in 1976 provided for an amount of $13,974 (10% of the estimated portion of the purchase price allocated by him to the buildings), and also deducted an amount of $3,732.46 as interest on a loan, the funds from which it was claimed were used to replace personal funds paid in the purchase of the property.

Contentions

For the appellant:

—The purchase price of $185,000* was for land and improvements. It was not acquired for redevelopment. It was acquired as a going concern and is retained as such. It is the improvements that are bringing in the rentals, not the bare land. An adequate amount should be allocated to these buildings, and other improvements.

—CCA is permitted by sections 20(1)(a) and 68 of the Income Tax Act.

— I have invested $45,490 at the time of acquisition and $6,922 during 1976 in the Waldorf Trailer Park. The money I have borrowed from the bank was for the repayment of my loan to the Waldorf Trailer Park. Without any doubt it was in connection with the acquisition of a revenue-producing property.

Actual cost agreed at $185,490, although sometimes in the documentation the price is referred to as $185,000. (Board Note)

For the respondent:

— no part of the $185,490 paid for the Waldorf Trailer Park property can reasonably be regarded as being in respect of property of Class 6 of Schedule B to the Income Tax Regulations.

—. . . of the interest claimed by the appellant as a deduction in computing income for 1976, $3,732.46 related to a personal use property of the appellant located at 967 Saturna Place in the City of Victoria.

Evidence

The significant points which can be established are:

—the Minister’s assessment for the year 1976 dealt with the property on the basis that it was operated as a business, only the cca was disallowed as indicated.

—the municipal assessment valuation for the property for the year 1978 was land $94,250 and buildings $53,600, and no material changes had been made in the property since the acquisition.

—the buildings were insured for $40,000.

—the appellant operated and still operates a grocery store immediately adjacent to the property.

According to his testimony, the appellant had been supplied with a statement of revenue and expenses for the year ended December 31, 1974 before he purchased the property, and he had based his decision to buy on the results shown. A document identified by the appellant as this statement and indexed as Exhibit A-4 was presented to the Board. The main features from it are:

Also, it was the appellant’s testimony that he had originally put $50,000 of his own money into the purchase, and had withdrawn this later when he was able to substitute borrowed money. He could not identify or describe accurately the source of these funds or their flow, when evidence regarding substantial borrowings for a personal residence was introduced by counsel for the respondent.

Mr David Osland, of Baker & Osland Appraisals Ltd, presented and explained a valuation report he had prepared with respect to the property (Exhibit A-1). The basic conclusions of this appraisal were:

Page 7:

The subject motel/trailer park operation is considered to have been generating sufficient income at the appraisal date to preclude site redevelopment and therefore, the existing use was considered the highest and best use at the appraisal date.

Page 8:

VALUATION PROCEDURES

The valuation of the subject property will be made on the following basis:

(1) The depreciated replacement cost of the improvements to which is added the land value. (The Cost Approach).

(2) Analysis of revenue obtainable from the property on the premise that the present worth equals the sum of expected future benefits. (The Income Approach).

Note: A value premised on market comparables is precluded by the lack of sufficiently recent and comparable sales evidence.

Pages 13, 14 and 15:

THE INCOME APPROACH

Included in the addenda section of this report is a copy of the 1974 operating statement for the subject property. In projecting a 1975 statement the following alterations/amendments have been made for appraisal purposes:

(a) Revenue—the 1974 revenue of $20,437.31 will be increased by 10% for 1975, and an additional $100/month added for personal use of the residence (ie rent of $60/month indicated in statement considered low and $160/month is considered economic rent).

(b) Expenses—the expenses of $10,175.22 will be amended with the reduction of $514.65 for car, $609.28 and $150.28 for interest, and $116 for automobile insurance. This new (revised) expense amount will be factored by + 10% for 1975.

This indicates a 1975 operating statement of:

Gross Income Projected
$20,437.31 x 1.10 =			$22,481.04
Plus $100/mos x 12 =			$ 1,200.00
			$23,681.04
Less Expenses
		$10,175.22
less	—	514.65
		609.28
		150.69
		116.00
	$ 8,784.60 x 1.10 =		$ 9,663.06
Net Income Projected (1975)			$14,017.98

This projected net income, in turn, indicates a property value of:

Net Income to Land & Improvments	$14,018
Less Income Attributed to Land
($113,700 @ 7%)	- 7,959
Income Imputed to Improvements	$ 6,059
Capitalize @ 11% (7% plus 4%
recapture)	$ 55,082
Add Site Value	$113,700
Property Value Indicated by Income
Approach:	$168,782
Say:	$168,800
CORRELATION AND FINAL VALUE ESTIMATES
Property Value Indicated by Cost Approach	$172,200
Property Value Indicated by Income Approach	$168,800

The property values found by the two approaches fall within a narrow range of $3,400 or approximately 2%, and both are considered of equal reliability in estimating the property value.

I am therefore of the opinion that the market value of the subject property, as of December 15, 1975, is the middle value and was:

$170,500.

ascribing $113,700 to the site and $56,800 to improvements.

As to the property sold on the appraisal date for $185,000 I have concluded that the difference between the appraised value and sale price ($14,500) may be imputed to business goodwill of the subject operation.

Mr W H Southward, an appraiser with Revenue Canada, supported the following conclusions from his valuation report (Exhibit R-1):

From page 14:

DATA CLASSIFICATION AND ANALYSIS

To determine an estimate of value, the appraisal process envisages the use of three approaches; The Cost, Market Data, and Income Approach. Any one of these will be applied only when it has application and support.

In this instance, all three approaches will be explored.

From page 19:

THE COST APPROACH

Our concluded land value, as if vacant and available for development, is $2.67 per square foot, or 72,884 x $2.67 for $194,600.

Cost Approach Summary

Depreciated Improvement Value	$ 36,000
Land Value	194,600
	$230,600
THE INCOME APPROACH

The Income Approach capitalizes the net income generated by the property by a rate which an investor would require to provide a return equal to the risk of investment.

Indicated revenue for the year ending 31 December, 1974, and 1976, was $20,437 and $22,763, respectively. Since no financial statement was provided for 31 December, 1975, the estimated gross income at the sale is estimated at $22,500.

The Income and Expense Statement has been reconstructed as follows:

Gross potential rental income	$22,500
Vacancy or rent loss, 5%	1,125
Effective gross income	$21,375
Effective Gross Income (carried forward)	$21,375
Expense:
Taxes	$ 975
Insurance	196
Management, 5%	1,125
Heat	2,400
Utilities	3,312
Garbage Removal	312
Wages & Benefits	780
Supplies	154
Miscellaneous	225
Repairs & Maintenance	1,400
Total Expense	10,879
Net Income before Depreciation	$10,496
Property Value based on an overall Capitalization
rate of 10%	$104,960
Rounded to	$105,000
Property Value based on Straight Line Capitalization
Net Income	$10,496
Income attributable to the Land at 9% return rate
Say, $194,600 x .09 =	$17,514
Income remaining to the Improvements	NIL

The net income, as such, does not provide a satisfactory return for the land value only, so there is no income remaining which would be attributable to the improvements. They do not, therefore, add to the value of the property.

From Pages 21 & 22:

CORRELATION OF VALUES

The estimate of value based on the Cost Approach is $230,600.

The analysis of the Income Approach shows that the present operation is not an economic one.

The Market Data Approach cannot be developed because of the absence of sufficiently similar comparable sales.

The trend in the area is for the old motel-type properties being re-developed commercially. It is illustrated by the comparable land sales that there is a steady demand through the district for land with commercial potential. The value of the subject property is therefore, considered to be in the land value which is $194,600.

CONCLUSION

The subject property sold in an arms-length transaction, as at the appraisal date, for $185,000, which is $2.54 per square foot, based on the land area of 72,884 square feet. This price is considered to be the best indicator of value; it is within 5%, or reasonable tolerance, of the appraised value.

It is therefore concluded that the value of the subject property, legally described as Lot A, Section 1, Esquimalt District Plan 14038, as of 12 December, 1975, is:

$185,000

On an allocation basis, this is broken down as:

Land	$185,000
Improvements	Nil
Total	$185,00

One significant point agreed to by both valuators was that some time subsequent to acquisition, the appellant had severed a portion of the prop erty for some other purpose. While there was some variance of opinion regarding the amount of negative effect this had on the property, it was agreed such action had made it more difficult at least, to ever rezone the property for expanded commercial use.

From a comparison of the two valuation reports noted above, and from the comments of the appraisers, it was evident that one major point of departure came with regard to a determination of the results of the income approach to the problem. In effect, Mr Osland having arrived at a valuation of $113,700 for the land applied a minimum rate of return factor and a high capitalization factor to a projected total income figure which then resulted in a net valuation he could attribute to the buildings. Mr Southward, on the other hand, had arrived at a much higher land value to begin with, $194,600, and then applied a higher rate of return factor, and a lower capitalization factor to a projected total income figure, producing in effect a “deficit”’ position which might be ascribed to the buildings. With regard to the two “projected total income” figures (Osland $14,018 and $10,496), while there were some minor variations in the factors taken into account, the major area of differences was that Osland added into gross revenue an amount of $1,200 per year for personal use of a residence, while Southward made an allowance for vacancy loss.

Argument

The agent for the appellant pointed out that the taxpapyer was entitied to take his own money out of a venture and having so substituted, to charge as an expense the interest thereon. On the valuation issue he pointed out that in addition to the report submitted, there was the evidence of the insurance coverage and the municipal assessment. The agent also recognized that the operating results as a business did not support the acquisition of the property, and attempted to overcome this by alluding to other possible benefits or advantages (capital gain, availability for expansion, etc).

Counsel for the respondent, on the interest question, contended that the only evidence provided was presented by the respondent, and it supported a conclusion that whatever was the purpose of any payment claimed, it had not been shown by the appellant that it related to a loan used in the purchase of the property. On the issue of the valuation, counsel argued that the evidence presented by Mr Southeard had withstood examination and cross- examination, and should be accepted, whereas that of Mr Osland had shown substantial deficiencies. Following the judgment of the Federal Court, Trial Division, in A-G Canada v Matador Inc and Matador Converters Co Ltd, [1980] CTC 51; 80 DTC 6018, since Mr Southward’s valuation showed the land to be of more value than the total purchase price, the Board should accept the conclusions of that report—land $185,000; building Nil—and attribute no value of the buildings in this appeal.

Findings

The Board agrees with the agent (notwithstanding the conclusion reached by Mr Osland) that the operation did not and does not commend itself as a business investment. That might well be of importance in the event that the issue before the Board had to do with a capital or income account question with regard to gain realized, but it is not of direct relevance in the instant appeal. The simple fact is that the appellant did acquire a business, and continued to operate it as a business. He is entitled to charge capital cost allowance on the depreciable assets acquired and used. What perspective should be taken in the final analysis of any balance of the purchase price is not to be determined in this appeal.

On the interpretation of Matador (supra) raised by counsel, it is my view that the respondent’s valuation in Matador (supra) was $200,000 land—$300,000 building, but that the evaluator’s conclusion was identical (by chance) to the conclusion of the evaluator in this case—$185,000 land, nil buildings. The result of the Matador (supra) Federal Court judgment was to allocate the purchase price of the assets in the relative proportions ultimately agreed to—$200,000 land ( /s) and $300, 000 building ( /s) irrespective of the amount paid.

Turning to a comparison of the two evaluation reports, the Board notes that they were both done and explained in a professional and direct way. To his credit, Mr Osland agreed there were certain inaccuracies in his report and attempted to account for them. In the final result, however, his conclusion remained the same. Basically, the reports differ in their result because Osland determined the land value at $113,700 by the standard method of analysing comparable sales of property. Southward did the same thing but used different properties as comparables and reached a valuation of $194,600. At the hearing, Osland first suggested a new set of comparables, then agreed to use the Southward comparables, but pointed out that the reason his result would be about the same ($113,700) was because he would simply make greater allowances (averaging 35 to 40%) for location and zoning than Southward had allowed.

An examination of the comparables used (finally those of Southward) and the results obtained is very illuminating when done in the following way:

For the best comparables Southward could put forward, an average adjustment of -8.2% was required to bring about a relationship with the subject property as he saw it. For Osland, that adjustment was -43.2% for the result he obtained using the same comparables. I would make the general observation that comparables requiring adjustments averaging -43.2% are hardly comparables on which any evaluator should seriously rely. Osland’s original list of seven comparables (using the same basis as above) would have produced an average adjustment of -15% but it was discarded as unreliable by Osland; and that was also the fate of his alternate list of comparables which would have shown an average adjustment of -19%. As I see it therefore, there have been no comparables presented by the appellant which could serve as any reasonable approximation of the value of the property in dispute here. Whether or not the comparables in the schedule above showing an average deviation of -8.2% for purposes of the Southward report are indeed comparables, it is not necessary for the Board to decide. At least that deviation percentage makes a realistic comparison possible. Since Osland cannot accept that deviation percentage as equitable, then in my view he cannot claim them as comparables and adjust them at the same time by -43.2% without some exceptional circumstances to warrant it. I readily admit that there are areas of the Southward report which also leave me uncertain as to its conclusion that the land value was $194,600, but these reservations are considerable less than can be seen in the Osland report. The Southward report must be judged only against the other two points put forward by the agent—the insurance coverage and the municipal assessment. Both of these are indicative but neither is determinative, but they do tend to corroborate rather than contradict the Southward report in its “Cost Approach’’ valuation, “Depreciated Improvement Value $36,000, Land Value $194,600—Total $230,600”.

In my view, to decide this appeal using the Southward report valuation ($230,600), not its conclusion ($185,000), would be in accordance with the judgment of Matador (supra) and in the result there should be a proportionate breakdown of the purchase price according to the respective values which resulted from such valuation:

On the interest issue ($3,732.46), the Board simply notes that the appellant has failed to discharge the onus of proof placed upon him under the Income Tax Act on two grounds—to show that such a payment was ever made, and if made that it was for the business purposes proposed.

Summary

The only viable evidence upon which the Board can determine the allocation requested is the Southward report, and that produces a valuation attributable to the buildings of $28,960 as at the date of purchase of the property.

Decision

The appeal is allowed in part in order that the taxpayer may consider the value of the improvements acquired at $28,960, and charge capital cost allowance according to the provisions of the Income Tax Act for the two years 1975 and 1976. The matter is referred back to the respondent for reconsideration and reassessment accordingly. In all other respects the appeal is dismissed.

Appeal allowed in part.