Pradeepan v. R., [1997] 2 CTC 2015

Bowie T.CJ.:

The issue in this appeal is whether or not the Appellant is entitled to claim certain losses incurred by him in connection with a rental property as business losses which may be deducted from his other income. Briefly put, the Appellant’s position is that he was engaged in a business venture, the losses from which are deductible, and the Minister’s position is that the Appellant did not have a reasonable expectation of profit from the renting of this property in the years in issue, that the losses were personal or living expenses of the Appellant, and that in any event the expenses giving rise to the losses were not reasonable, and should therefore be disallowed under section 67 of the Income Tax Act (the Act). The years under appeal are 1989, 1990 and 1991.

The Appellant is a professional engineer who came to Canada as an immigrant and settled in Toronto. In 1988 he met Velauthar Karalamoorthy and his wife Chandrapraba, whom I shall refer to hereafter as the partners. They decided that there was money to be made through investment in rental real estate. At that time the real estate market in the metropolitan Toronto area was active, there was a high demand for residential units to rent, and the prospects for profit seemed good. They made some investigation of the potential rents that could be charged; the Appellant said that he looked at the classified advertisements in the newspapers and talked to some real estate agents. I do not think that the investigation was a very thorough one, but I believe that he did at least make some rudimentary enquiries. They also looked at a number of properties that were available for purchase, eventually settling on a townhouse condominium project that was being built in the north-east sector of the city at that time, called Morningside Village, Phase I. On December 18, 1988, they entered into an Agreement of Purchase and Sale with the builder to acquire unit 34 in that project, a townhouse with three bedrooms and a bathroom on the second floor, the kitchen, a half bathroom and living and dining areas on the main floor, and a finished basement with a walk-out which, with some modification, could be made into a one bedroom self-contained flat.

The Appellant could not produce a business plan of even the most rudimentary kind at the trial, although he said that he had had one when he and his partners embarked on this project. However, I believe his evidence, which was to the effect that he and his partners had a plan which involved renting the property as two residential units, the basement being one and the two upper stories being the other. They expected to get $1,000 per month rent for the upstairs, and $500 for the basement, for a total monthly rental income of $1,500. The alternative, as they saw it, was that they could, if necessary, rent the entire townhouse to one tenant for $1,300 per month.

The purchase price of the townhouse was $202,490, of which about $38,000 was to be paid in cash at or before closing with the balance made up of a first mortgage for $151,800 and a second mortgage for $13,200. At the time the offer was signed the builder was promising a first mortgage rate of 9% per annum; this was not spelled out in the offer, however, and by the time the transaction closed the mortgage rate had risen to 12% per annum. The Appellant expected to get about $13,000 in cash from some overseas source, but as this was not available before the closing date the second mortgage was required. It bore interest at 16% per annum, and it was paid off by the Appellant at the end of its one year term. The closing, originally scheduled for May 19, 1989, did not take place until January 18, 1990, because of delay in obtaining registration of the condominium corporation. The Appellant and his partners took possession in May 1989, however, and paid an occupancy fee of $2,213.11 per month until the closing date. The Appellant took a 50% interest in the property; his partners shared the remaining 50% equally.

The Appellant and his partners advertised for tenants immediately upon taking possession of the townhouse, but almost immediately their plans were thrown into disarray. It is clear now, with the benefit of hindsight, that the real estate rental market in Metropolitan Toronto had reached its peak and was in decline by the end of the 1980s. It was not as easy to find tenants as they had expected, nor were the rents obtainable as high as they had thought they would be. The situation was aggravated by the fact that the project was not completed; even after the closing in January 1990 there was work being done on the internal road system and the landscaping, which lessened the attractiveness of the property for prospective tenants. Instead of the $1,500 per month that they had hoped for, or even their backup position of $1,300 per month, they found themselves with only one tenant at a rent of $1,000 per month from July 1989 to March 1990. He was replaced by a second tenant who paid $1,100 per month until he was evicted in August 1990 for non-payment of rent. In the meantime the condominium corporation, soon after the January closing date, had passed a bylaw which prevented owners of units having a basement walk-out from using it as a separate entrance so as to permit them to rent two separate units. As a result of this, and of the difficulty that they were experiencing in obtaining a tenant for the whole unit, the Appellant and his partners decided to rent the bedrooms separately. They hoped that this would produce a monthly income of $400 for each of the four bedrooms, a total of $1,600 per month. However, they were only able to obtain two tenants, each paying $300 per month, with the result that the total income between September and December 1990 was $2,400, less than one-half of the amount on which their plans were based.

In the face of these problems the Appellant decided to limit the losses that he was suffering by moving into one of the empty rooms in the townhouse, rather than continuing to pay rent of $400 per month for his Share of the apartment that he was living in. He and the two tenants were the only occupants thereafter throughout the years under appeal. In 1993 the Appellant bought out his partners’ share of the unit, and at about the same time he married and his wife moved into the house with him. He and his wife continue to live in the townhouse, with the two tenants. At trial he testified that they plan to move out of the unit in the middle of 1997, because they wish to have more privacy than the present arrangement permits.

Counsel for the Minister argued that this case falls into the class described by Linden J.A. in Tonn v. R. [1] as ’personal benefit and hobby type cases’, because the Appellant has been living in the house now for almost six years. I do not agree. I believe the Appellant’s evidence that his original intention was that the property would be strictly a rental property, and that he moved into it only to make the best that he could out of the disastrous financial situation that had developed. It would not have been sensible for him to continue to pay rent elsewhere when he had rooms which he could not rent in this townhouse.

Counsel submitted that even if this is not viewed as a personal use case the appeal must fail because the circumstances of the investment, viewed objectively, are such that it could be seen from the outset that the venture was an ill-fated one which could not possibly produce profits. In particular she points to the high rates of mortgage interest being paid on the two mortgages, the relatively small amount of the Appellant’s own money that was paid on closing as compared to the amounts of the mortgages, the lack of a carefully researched and written business plan, and the very sizable losses incurred between 1989 and the present time. The losses claimed for the three years under appeal, without any consideration of capital cost allowance, are:

A further significant loss seems to have been incurred in 1992, with a break-even point being reached in 1993, the year in which the Appellant bought out his partners’ interest.

Understandably, counsel pointed also to the fact that some of the Appellant’s claims for expenses were clearly unreasonable as support for her position that the losses should be disallowed on the basis that they do not survive the application of the reasonable expectation of profit test promulgated by Dickson J. (as he then was) in Moldowan v. R. [2] .1 agree that some of the claims made by the Appellant cannot be justified under proper accounting principles. His allocation of the losses claimed in certain years is also not justifiable. He purported to make adjustments for such things as the excessive second mortgage interest, which he said was attributable to him rather than to his partners because he did not have his full share of the cash on closing, and for some informal and unproved agreement as between himself and his partners which would vary their allocation of profits from the original, and logical, 50/50 split. I am satisfied by the Appellant’s explanations, however, that these adjustments were well-intended, and that they result not from any avarice on his part, but from his ignorance of proper accounting methods. Many of these amounts were addressed during the Appellant’s evidence-in-chief, and were specifically abandoned by him, or by his counsel on his behalf. Principal among these was the interest on the second mortgage, which his counsel indicated was no longer being claimed as an expense. Had it not been abandoned, I would certainly have found this item to be unreasonable and would have disallowed it under section 67 of the Act.

Applying the law as it has been laid down in Moldowan, and explained in Tonn, I do not conclude that this is a case where it should be said that the taxpayer was so obviously engaged from the start in an enterprise that could not succeed as to disentitle him to the deduction of his losses during the early years of the venture. The critical passage in the reasons of the Court of Appeal in Tonn, for purposes of the present case, is the following [3] :

... I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other- than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way Suspect.

I have already expressed the view that this is not a personal use case. The excessive claims that I have referred to above certainly warrant close scrutiny of this case, but I am satisfied by the Appellant’s explanations. I do not mean by that to say that all of his claimed expenses are justifiable, but simply that close scrutiny convinces me that this is a case in which the motive was profit. I do not think that the Appellant and his partners executed their plan with much business acumen, but there is no principle which taxes the profits of inept businessmen, should they make any, while denying them the deduction of their losses. In my view the Appellant is entitled to succeed in his appeals.

This does not end the matter, however. As I have said above, the Appellant’s methods of accounting leave a great deal to be desired. His counsel and he conceded during the trial that many of the items of expense claimed were in fact capital in nature, and should not have been claimed as expenses at all. His allocation of the losses between himself and his partners was, at times, highly unconventional. The second mortgage interest was an unreasonable expense prohibited by section 67 of the Act. The assessments will be referred back to the Minister for reconsideration and reassessment on the basis that the Appellant is entitled to have a deduction in each of the taxation years 1989, 1990, and 1991 for his losses incurred in the operation of the property known as unit 34, 401 Sewells Road, Scarborough. Those losses are to be computed in accordance with proper accounting practices, and on the basis that no amount is to be allowed for interest expense on the second mortgage, and that the following items are to be treated as capital and not as expenses: legal fees, mortgage brokerage fees, water-meter hookup, exhaust fan installation, railings and curtains, and the new-home warranty fee. The Appellant is entitled to a 50% share of the losses only in each of these years, and 25% of the expenses are to be attributed to his personal use in the year 1991. I make no finding as to the proper attribution for personal use in later years, as they are not before me, but I simply point out that the proportion should likely increase for the years after his wife began living in the premises with him.

The Appellant has been substantially successful, and is therefore entitled to his costs.

Appeal allowed.