Monga v. R., [1997] 1 CTC 2529

McArthur J.T.C.C.: — These appeals were heard in Toronto under the Informal Procedures of this Court on common evidence with the appeals of Rajesh Monga and Edmundo Sanchez.

The issue is the deductibility of rental losses incurred by Mrs. Monga in the 1990, 1991 and 1992 taxation years. The amount of the losses claimed were $56,706.33 in 1990, $54,091.42 with capital losses of $140,000.00 in 1991 and $37,241.23 in 1992.

The Appellant purchased several properties. Some were purchased with partners and others were purchased by the individual Appellant alone. While some facts are in common, some facts are attributed to the Appellant alone. A determination of the issues is made individually in separate judgments. All three Appellants bought and sold or retained residential properties within a short period of time. The ownership was different in most instances and each Appellant’s purchases are dealt with separately.

One Maritza Ratti had been associated with the three Appellants in some common transactions. Her appeals were disposed of at the outset of the proceedings.

The Appellant and her spouse, Rajesh Monga, were real estate agents. Three of the four properties were purchased by the Appellant jointly with her spouse to facilitate mortgage financing, yet she retained 100% of the equity. In 1990, 1991 and 1992, the Appellant reported rental losses for these properties as follows:

The registered deeds, in many instances, did not accurately reflect the true ownership and purchase price of the properties as stated by the Appellant. The parties stated that the purchase price for 43 Hyde Park Drive was $315,000.00, for 8 Truro Crescent it was $152,500.00, and for 47 Stather Crescent it was $274,000.00. The Appellant presented the Court with rental projections prepared after the purchases of the properties which projected profits at least within a few years of each purchase. The evidence indicates that projections of income and expenses were prepared informally prior to each purchase and produced in writing years later for the purposes of these appeals. The projections were highly optimistic when scrutnized with the actual income and expenses.

Position of the Appellant

Written submissions were filed on behalf of the Appellant that read in part as follows:

The Appellant recognized at the time that real estate was a good long-term investment and acted in good faith and as a prudent entrepreneur when she invested in the aforementioned properties. They were purchased with the stated intention to be used as a source of property income.

The Appellant and her spouse were both real estate agents. From their profession, they have access to specific rental and real estate information similar to the acquired properties. With the aid of the MLS current and past data along with her work experience, she anticipated obtaining rental income of $2,600 throughout 1989 and 1990 from the Hyde Park Property, and further anticipated that yearly revenues would increase by approximately 5% in succeeding years. The mortgage principal would be paid down at an estimated rate of 5% initially with sources of funds from her earnings and in later years from the net profits.

Similarly, the Appellant anticipated obtaining rental income from the Truro Property of $1,100 per month initially, and further anticipated that yearly revenues would increase by approximately 5% in succeeding years. With the intention of certain repayments of the borrowed money, Mrs. Monga expected to begin earning profit starting in 1991. At this point, the mortgage would be reduced further by profits generated in addition to funds from other sources.

The Stather Property would generate rental income of $1,400 per month and based on similar projections above, it was expected to realize profit in 1993.

The Soho Property was estimated to be rented for $4,300 monthly with the anticipation of profits from its acquisition date.

On the basis of income and expense projections, the overall rental operations would be in a profitable position after the initial start up period of 2-3 years. As such, this venture was considered viable and had a reasonable expectation of profit. It was clear at the time of purchase that there was anticipation of positive cash flows from the investments after the initial start up period and thus, there was an expecttaion of profit. It was also expected that the rental income would be sufficient to cover operating expenses, and realized profits would be used toward the repayments of borrowed money. Moreover, the investments were intended to be long term with the prospect of income gain both from rental income and the appreciation of property value.

It was unfortunate for the Appellant that the profit potential from this venture did not materialize for the following facts and reasons;

1. Rental revenues fell short of what were expected. Initially the Hyde Park Property could not be rented during 1988, and 1989 because suitable tenants could not be found. The Appellant was hesitant to rent out the property without extensive background checks of potential tenants due to an incident involving another property whereby a criminal proceeding involving drug trafficking by the tenants caused the property to be left vacant. The Hyde Park Property was rented in 1990 for $2,400 per month and was vacant until the Appellant decided to convert it to her principle residence in 1991. In order to minimize her losses, it was also used as principle residence in 1988 and 1989 when it could not be rented out.

Similarly, the Truro Property was rented out during in 1990 for $1,000 per month and, the Stather Property was occupied by tenants for $1,200 per month beginning in 1991. The Soho Property was immediately occupied with rental income of $4,300 per month. The tenant also expressed interest in the purchase of the property. However, due to marital problems, both the lease and purchase agreements were dishonoured. The Appellant made every effort to rent the property for the same rate but was unsuccessful and settled for a monthly rate of $2,100.

2. A moratorium on rent increases announced in 1990 imposed rent decreases on rental units or froze rental prices for an unspecified term. The rental prices generally went into decline.

3. The onset of a deep recession and other market forces not only affected both the rental prices and all real estate market values, the Appellant’s earning was also negatively affected. As a successful real estate agent before the recession, she was horrified to see her earnings drop dramatically. This had not only affected the losses of value of her rental properties but resulted in the inability of meeting her intended objective of paying down the mortgages with earnings or profits that would have otherwise been generated from the rental operation.

4. The adverse affects of the above factors were increasing debts as it was not possible to attain positive cash flows. The situation had led to unforeseeable losses and placed the Appellant in a position of severe cash deficit. Upon realizing that the properties were not going to be profitable due to the reasons above and in an attempt to minimize operating losses and improve cash flow, some of the properties were disposed.

Counsel for the Appellant referred the Court to Tonn v. R., (sub nom. Tonn v. Canada) [1996] C.T.C. 205, 96 D.T.C. 6001 (F.C.A.) and to several cases quoted in Tonn.

Position of the Respondent

The Respondent submitted that the Appellant did not have a reasonable expectation of profit from renting of the Hyde Park Property, the Soho Crescent Property, the Stather Crescent Property and the Truro Crescent Property in the 1990, 1991 and 1992 taxation years. Counsel stated that the losses were personal or living expenses of the Appellant and that they were not incurred for the purpose of gaining or producing income from a business or property pursuant to paragraph 18(l)(a) of the Income Tax Act (the “Act”), hence the Appellant was properly reassessed in accordance with paragraphs 18(l)(a) and 18(l)(h) of the Act. In the alternative, counsel stated that the deduction of the disallowed rental expenses is prohibited by section 67 of the Act as they are not reasonable in the circumstances.

Analysis

The issues the Court is asked to consider are whether the Appellant had a reasonable expectation of profit and, if so, whether the expenses claimed are reasonable. All properties at issue were single residential units. The income and expense projections were prepared in writing for the purposes of these appeals. The Appellant was a real estate agent and familiar with residential real property in the vicinity.

At the commencement of the trial, the Appellants appeared to have the mistaken belief that the issue was whether the profit on the sales of the properties was on capital account or income account. They took the position that any profit on the sales of the units was capital. The Minister of National Revenue took the same position, accepting the net sale proceeds as capital gains or capital losses.

As I am reluctantly accepting the conclusion of both parties that the Appellant was not a trader in real estate, then why did she buy the properties? The expenses were not personal or living expenses. The Respondent suggests that the Appellant’s purpose in incurring the expenses was other than that normally associated with holding rental properties. Yet the Respondent states that the properties were held as capital assets, rather than for the purpose of resale. There was no element of personal enjoyment nor any suggestion that the activity of the Appellant was a hobby. It was not presented that the purpose was to obtain a tax advantage. I must conclude that the properties were purchased to earn rental income from the rental business.

The Appellant’s contention was that the properties would be carrying themselves in less than four years. While these projections were highly over-optimistic, it is clear from past jurisprudence that the Minister cannot use hindsight to second guess a taxpayer’s business decision.

Expenses were made or incurred by the taxpayer for the purpose of gaining or producing income from the properties within the meaning of paragraph 18( l)(a) of the Act.

This finding leads to the statement on page 212 (D.T.C. 6009) of Tonn (supra). Justice Linden recommended that where the Minister challenges the reasonableness of a taxpayer’s transactions, she should refer to section 67 of the Act and not to the heavy handed “reasonable expectation of profit” approach.

Section 67 states that an income deduction can be made only for reasonable expenses in the circumstances. The Court is required to determine what expenses are reasonable in the present circumstances.

I am not satisfied that the projections of income and expenses submitted were a duplication of projections prepared prior to each purchase. The properties were obviously undercapitalised. In order to expect a profit within a reasonable period of time, being at least within five years from date of purchase, sufficient capital would have to be paid to reduce the mortgage principal and, thus, substantially reduce the interest payments.

I cannot conclude that the interest expense is reasonable given that the financial structure on the properties during the relevant years required, in most instances, interest payments that were 30% to 60% greater than the income. For the annual interest expense to be considered “reasonable in the circumstances”, surely it alone should not generally exceed the gross annual income. This is particularly true in the present case where the Appellant did not have further capital to reduce the mortgage debt on the properties within the reasonable future. I conclude that, in the present circumstances, interest should not exceed the gross rental income in order to be considered a reasonable expense.

I believe that some of the other expenses claimed could more accurately be classified as capital expenses. These expense claims are reduced somewhat arbitrarily in keeping with an effort to apply with section 67 of the Act.

My conclusions are as follows:

1. 8 Truro Crescent - the interest is reduced from $19,220.56 to $11,550.00 for 1990 and from $10,145.54 to $2,100.00 for 1991 (so as not to exceed the gross rental income). The “other expenses” remain unchanged at $4,116.07 for 1990 and are reduced from $3,094.94 to $1,050.00 for 1991 (being equal to no more than 50% of the gross rental income).

2. 85 Soho Crescent - the interest is reduced from $40,974.00 to $26,000.00 for 1990, from $40,069.00 to $24,000.00 for 1991, and from $41,304.33 to $24,600.00 for 1992 (so as not to exceed the gross rental income). The “other expenses” remain unchanged at $5,378.95, $6,039.50, and $5,807.22 respectively, as they do not exceed 50% of the gross rental income.

3. 43 Hyde Park - the interest is reduced from $38,679.03 to $28,800.00 (so as not to exceed the gross rental income) and the “other expenses” remain unchanged at $4,550.84, as they do not exceed 50% of the gross rental income.

4. 47 Stather Crescent - the interest is reduced from $23,090.88 to $16,400.00 for 1990, from $31,284.00 to $14,400.00 for 1991, and from $24,858.67 to $14,400.00 for 1992 (so as not to exceed the gross rental income). The “other expenses” remain unchanged at $3,446.00, $3,958.44, and $4,271.01 respectively, as they do not exceed 50% of the gross rental income.

In summation, the losses attributable to Neera Monga are as follows:

1.: 8 Truro Crescent: 1990 $4,116.07

1991 $1,050.00

2.: 85 Soho Crescent: 1990 $5,378.95

1991 $6,039.50

1992: $5,807.22

3.: 43 Hyde Park: 1990 $4,550.84

4.: 47 Stather Crescent: 1990 $3,446.00

1991 $3,958.44

1992 $4,271.01

A more detailed review is contained in Schedule “A”, attached to this judgment.

The appeals are allowed and referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the above.

Schedule “A”