Morris v. R., [1998] 1 CTC 2957

Rip T.C.J.:

Mr. Morris, we have just heard the evidence before the break and I have heard your arguments. I don’t want to go through all the facts. The facts are pretty well set forth in the assumptions given by the Minister: that Mr. Morris purchased a property in November 1988 for $245,000. The property was financed with a first mortgage of $160,000 and a second mortgage of $38,000.

Now Mr. Morris stated that he assumed a 10% mortgage which had six months remaining and interest rates on the second mortgage which varied later on between 13% and 17%. When I say “later on”, I mean during the time in which he owned the property. Mr. Morris was indicating that interest rates were much higher than he anticipated they would be when he acquired the property in 1988.

Now the property consists of essentially three stories which Mr. Morris described as being a split level, five levels on the property, but essentially they were three stories. The basement was a self-contained unit in which Mr. Morris lived. The top two floors were available for rent. Each one of the two stories could have been rented.

In 1991 there was one tenant for the first half of the year, a different tenant in the second half of the year and an additional tenant in December of 1991.

In 1992 Mr. Morris was renting the property. There were two different tenants, that is on the second and first floor. And in December of 1992 a family moved into the property and that family lived on the property until Mr. Morris sold the property in 1997.

Mr. Morris acquired the property after a separation from his wife and he acquired the property since, in his view, real estate was the best way to make a profit. And with real estate prices escalating in Toronto in the mid 80’s, he anticipated that prices would continue to escalate and, therefore, he purchased this property.

In the meantime he indicated that he would rent the property, which he did so almost immediately after purchasing the property. However, he stated within almost two weeks of buying the property, property values in Toronto fell apart, to use his words. The property values fell even before he moved in. He had signed an Agreement of Purchase and Sale on November 14, 1988 and the transaction closed on November 30, 1988.

Mr. Morris indicated that he had friends who lived in the area of the property in question and when they tried to sell the property after November 1988, he found that they could not get even anything close to what he paid for the property.

In Mr. Morris’s view, there were a lot of units available for rent in the area since people were losing their jobs at the time and decided to rent rooms or floors to supplement their income.

Now when Mr. Morris acquired the property, he did not have any idea of how much rent he could get from the property. He did not know the market value of the property when he acquired the property. When I say “the market value”, I mean the market rental value of the property at the time of acquisition. In short, he hoped to get a profit on resale of the property. Unfortunately, when he sold the property in 1997, he sold the property for approximately $192,000. That is at a loss.

In none of the years in which Mr. Morris owned the property was there a profit. Although for the years 1988, 1989 and 1990 it appears Revenue Canada permitted Mr. Morris to deduct his loss from his income, Revenue Canada had a change of heart when the 1991 taxation year was assessed and disallowed rental loss for 1991, 1992 and 1993, the years in appeal.

In 1991 Mr. Morris had rental income of 11-'/2 thousand and rental expenses of $26,184.00. In 1992 he had income from property of $15,000 and had expenses of $20,532. In 1993 he had income from rentals of $12,000 and had expenses of $17,086. So in 1991, 1992 and 1993 he incurred rental losses of $14,684, $5,532 and $5,086 respectively. The losses continued in subsequent years.

In 1994 his income from property was $12,000, expenses were $16,437 for a rental loss of $4,437.

Now the bulk of the expenses claimed by Mr. Morris was on account of interest on mortgages. For example, in 1991 interest expenses approached $18,000, in 1992 interest expense was $14,939 and in 1993 interest expenses exceeded $14,000.

Now the property acquired was acquired by Mr. Morris and he lived in the basement of the property. So at least a portion of the property was or could be categorized as is his principal residence.

Now there have been many cases over the past few years with respect to the allowance or disallowance of rental losses. A leading case on business losses is that of the Supreme Court of Canada in Moldowan v. R., reported in (1977), 77 D.T.C. 5213 (S.C.C.). This was a farm loss case. Mr. Justice Dickson, as he then was, considered what the words “reasonable expectation of profit” mean.

I want to read for the benefit of Mr. Morris the thoughts of Mr. Justice Dickson:

Although originally disputed, it is now accepted that in order to have a ‘source of income’ the taxpayer must have a profit or a reasonable expectation of profit.

I will just skip ahead, and he says personal and living expenses which are defined in s. 139(1 )(ae) of the Income Tax Act.

And what Mr. Justice Dickson says is, personal and living expenses are not deductible for tax purposes. The expenses of properties maintained by the taxpayer for his own use and benefit, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit are not deductible.

And I am not reading directly. I am trying to paraphrase what he is saying. If the taxpayer is operating, for example, a farm with no reasonable expectation of profit he is merely indulging in a hobby. He is not entitled to deduct the expenses.

Then Mr. Justice Dickson states:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view...

And this I am quoting.

...whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive.

Now there was a recent decision of the Federal Court of Appeal in Tonn v. R. which questions whether Mr. Justice Dickson’s comments were still relevant. And the Federal Court of Appeal, on several occasions, had the opportunity to consider and review its own decision in Zonn v. R..

Now I just want to read a portion of that from the case of Brill v. R. (1996), 96 D.T.C. 6572 (Fed. C.A.) and I am reading from 6577. And I will just read what is stated by Mr. Justice Linden of the Federal Court of Appeal.

The other case relied on by the taxpayer was Tonn v. R....

And Tonn v. R. is reported at (1995), 96 D.T.C. 6001 (Fed. C.A.). And I will just continue.

The other case relied on by the taxpayer was Tonn v. R. where deductions for interest inter alia were allowed on loans taken out to buy residential units for the purpose of making rental income. When the hope(sic) for profit did not materialize, the Minister had sought to disallow the deductions on the basis of Moldowan to the effect that there was no reasonable expectation of profit during the years in question. This Court, reversing to the Tax Court Judge, held that the deductions were properly allowed and suggested that Moldowan be used sparingly in cases where there was no personal element or suspicious circumstances. It is said also Moldowan not be used to second guess good faith business judgments that were flawed.

And he continues:

There was nothing in Tonn v. R., however, to indicate that the Moldowan principle was not to be applied in cases where interest expenses were deducted in situations where there was no reasonable expectation of profit. The Moldowan test, however, should not be used in paragraph 21 (c)(i) cases unless it is clear that no profit is likely to be earned in the taxation year. In cases such as this, therefore, where it is clear that no profit could be earned in the year or for ever after because of the judicial sale proceedings...

Which is not within your case.

...Moldowan is applicable.

He adds:

In cases where it is not clear whether that profit will be earned eventually, Tonn v. R. teaches that taxpayers should be allowed the deductions, when profit is not in fact earned. But where, as here, no profit is possible in the taxation year and thereafter, the deduction cannot be permitted.

The Federal Court of Appeal in the case that Ms. Welsh referred to is that of Mohammad v. R. (July 28, 1997), Doc. A-652-96 (Fed. C.A.) which was rendered on. The Federal Court of Appeal continues in the same vein, as Ms. Welsh mentioned, Mr. Justice Robertson states that:

In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement.

In this case, Mr. Morris, the interest you had to pay was extremely high. The fact is that it exceeded your income, the rental income from the property.

I am just continuing with Mr. Justice Robertson’s statements:

The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima facie, to satisfy the reasonable expectation doctrine. These are not cases where the Tax Court is being asked to second-guess the business acumen of a taxpayer whose commercial or investment venture turns out to be less profitable than anticipated. Rather these are cases where, from the outset, taxpayers are aware that they are going to realize a loss and that they will have to rely on other income sources to meet their debt obligations relating to the rental property.

Now, Mr. Morris, the situation in your case was that you did not take proper or reasonable precautions to know what rent was possible in the area in which you acquired that property. That was your evidence. You didn’t know what the market of rents were at the time in that area. So I have difficulty in permitting you to deduct these expenses.

I don’t want to read all the rest of the Mohammad case that Ms. Welsh referred to, that is paragraph 8 and paragraph 9, in which in my view there was no second-guessing. A reasonable business person, prior to acquiring a property, sets out what his possible rents could be, what his expenses will be and makes a calculation of whether there will be a profit or not. In your case you did not do that. So it is not a matter of second-guessing here.

It is clear, in my view, that you are not entitled to the deductions you claim and that the assessment ought to be maintained. I’m sorry.

The appeal will be dismissed.

Signed at Ottawa, Canada, this 24th day of October 1997.

Appeal dismissed.