Costello v. R., 98 D.T.C. 1362, [1998] 2 C.T.C. 2832

Bowman T.C.J.:

1 These appeals are from assessments for the 1992, 1993 and 1994 taxation years. They involve the deductibility of rental losses incurred by the appellant in those years.

2 The appellant has been engaged as a high school teacher by the Scarborough Board of Education. She has had considerable business experience in addition to her teaching career. In 1986, she formed the Ambrosia Construction Company which engaged in the renovation of commercial property. She carried this business until 1990. She has also been involved in furniture sales and fashion design of children's clothing.

3 In 1985, she bought 115 Hannaford Street for $80,000 as her principal residence. It was located in the Beaches area of Toronto and was a single semi-detached dwelling and she leased portions of it to tenants.

4 In 1989, Ms. Costello became engaged and planned to live with her prospective husband. She therefore sold the Hannaford property in 1989 for $220,000 at a profit of $140,000.

5 Ms. Costello, with the advice of, and on the recommendation of a realtor, began looking for a rental property in the Beaches area of Toronto. Her intention was to utilize the property as an investment for rental purposes. It is clear on the evidence that she had no intention of purchasing a house in which to live.

6 She found a two storey house at 220 Silver Birch Avenue in Toronto which she purchased for $320,000. The down payment of $150,000 was made from the proceeds of sale of the Hannaford property and the balance of the purchase price was financed with a mortgage of about $170,000.

7 The property appeared to meet exactly Ms. Costello's requirements. It contained a basement apartment of about 510 square feet and an apartment on the ground and second floor of about 1,020 square feet. It was close to public transportation, schools, parks and restaurants, and to the downtown Toronto core. Her research indicated a shortage of rental property in the area. The vacancy rate was low and rents were rising. She understood that the rental market would continue to be robust.

8 Accordingly, she bought the property on July 26, 1989. On that day as well she moved into her fiancé's home.

9 It was a condition of the purchase that the construction of the basement apartment be completed by the date of closing.

10 She rented the upper apartment to three tenants for $1,300 per month and the basement for $750. Heating and hydro were paid by the tenants. The appellant paid insurance, taxes and maintenance. Her projections were that the house would start to carry itself in three years.

11 Toward the end of 1989 she broke up with her fiancé. Having sold her previous residence, she decided to move into the upper apartment. Two of the tenants moved out and one remained whom she charged $400 per month.

12 The second thing that affected her plans was the economic slowdown in 1990 and a surplus of apartment that appeared in the Beaches area.

13 The tenant in the basement moved out and she could not replace him at the same rent. She was obliged to accept $600 per month from a tenant and she had to pay the utilities.

14 Furthermore, she had to make extensive repairs. A damaged drain caused flooding and required expensive repair. New windows had to be installed in the basement. The furnace had to be repaired. A new refrigerator and carpet were needed in the basement.

15 To meet the loss of income and the increased costs of operating the rental business the appellant took a second job in a furniture store.

16 In order to increase the rental space, she removed the cathedral ceiling on the first floor and put in another bedroom. Rent from the basement apartment dropped to as low as $550 although now it has increased to $675 per month.

17 In 1993, she had no rental income from the upstairs because she was doing renovation. Moreover in 1994, she put new vinyl siding on part of the house.

18 This strikes me as a perfectly clear case. Ms. Costello is an educated, intelligent woman who went about finding an investment property in a rational, businesslike way. Clearly the property was acquired to earn income and her projections were reasonable. A number of matters converged however to frustrate her expectations. The first was the break-up with her fiancé, which resulted in her taking over a portion of the property. The second was the extensive and unforeseen repairs that needed to be done to the property. The third was the downturn in the economy and the change in the rental market.

19 I find as a fact that the rental operation had a reasonable expectation of profit. Indeed her loss for 1995 was nominal and by 1996, as a result of the repairs and renovations that she did, the decline in mortgage rates and generalimprovement in the rental market, she began earning a net profit and expects to continue to do so.

20 What I find unacceptable about the assessment is the tendency, (which I thought had been nipped in the bud by such decisions of the Federal Court of Appeal in Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.), Mastri v. R. (1997), 97 D.T.C. 5420 (Fed. C.A.)and Mohammad v. R., [1997] 3 C.T.C. 321 (Fed. C.A.)) once a loss is reported, to intone the ritual incantation of “no reasonable expectation of profit” and deny the losses. Here there was apparently no analysis of the losses. The most obvious thing about them is that a portion of the expenses claimed may (I emphasize may) have been capital in nature. I have in mind such things as the extensive renovation of the upstairs apartment, the removal of the cathedral ceiling and the construction of a third bedroom.

21 Another line of enquiry that the assessor might have followed would have involved a consideration whether in any year it was reasonable to attribute only 50% of the expenses to the appellant's personal use.

22 These questions raise legitimate concerns. They were not addressed at the assessments level, the appeals level, the reply to the notice of appeal or in the argument or evidence. In this I imply no criticism of counsel for the respondent, who presented the Crown's case with his usual skill. Mr. Bornstein did not draft the reply to the notice of appeal. It was drafted by someone who described himself or herself as “agent of the respondent”.

23 The officials of the Department of National Revenue appear to have been mesmerized by the recitation of the mantra “no reasonable expectation of profit” and to have overlooked the elementary point that had the losses or profits been properly computed (and in particular had an appropriate distinction been made between capital and revenue expenditures) there might have been either a substantial reduction in the losses claimed or possibly even a profit.

24 Had the respondent chosen to contend that some of the expenses were capital in nature she should have raised this point in the pleadings, and alleged such facts as were necessary to support such a contention. (See Minister of National Revenue v. Pillsbury Holdings Ltd. (1964), 64 D.T.C. 5184 (Can. Ex. Ct.)). On such an issue the respondent would of course borne the onus of proof. The respondent completely failed to do any of these things and it would have been patently unfair for the appellant to be forced to meet a case that was not pleaded.

• (a) They had not been proved. In fact they were meticulously proved.

• (b) They were personal or living expenses. A portion of course were, but this was recognized by the appellant's attribution of 50% to personal use and this allocation was not challenged in the pleadings or in the evidence.

• (c) There was no reasonable expectation of profit. Clearly there was. The allegation of a lack of bona fides in the letter of October 6, 1995 to the appellant is wholly without foundation.

26 The assumptions upon which the assessments were made have been demolished. No alternative basis for upholding the assessments has been advanced or established. I believe however that some of the expenditures may be capital in nature. This leaves me one of two alternatives. I could simply allow the appeal and direct that all the expenses claimed be deducted or I could refer the matter back to the Minister of National Revenue for reconsideration and reassessment to determine which of the expenditures are capital expenditures to be added to the undepreciated capital cost of the property. The latter course of action seems more appropriate (cf. Sokolowski v. R. (1996), 96 D.T.C. 6353 (Fed. C.A.)). The evidence before me does not permit me to make such a determination. The resulting reassessments should be premised upon my finding that the appellant had a reasonable expectation of profit, that the expenditures claimed had been adequately proved, that the allocation made by the appellant between business and personal use was appropriate and that the losses so computed be allowed as deductions. Therefore the appeals for 1992, 1993 and 1994 are allowed withcosts and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.