Nicholson v. R., [1998] 2 C.T.C. 2934

Bowie T.C.J.:

1 These appeals concern the Appellant's claim to be entitled, when computing his income under section 3 of the Income Tax Act (the Act), to deduct from his other income the losses sustained by him in connection with renting two apartments. The Minister of National Revenue (the Minister) has reassessed him for the 1992, 1993 an 1994 taxation years, to disallow the losses claimed of $9,708, $7,447 and $5,752, respectively. The Minister's contention, shortly stated, is that in the years in question the Appellant did not have a reasonable expectation of making a profit from the rental operation, and that it was therefore not a business, and not a source of income within the meaning of that expression as it is used in section 3 of the Act.

2 In 1984 the Appellant and his wife, foreseeing retirement, sold their house and purchased a triplex in the village of Jasper, which is about 10 kilometres from Smiths Falls, Ontario. It consisted of three living units, the largest of which they moved into with their family. The two smaller units were rented to tenants who remained for some years after the purchase and paid a monthly rent of $220.00 each. These tenants eventually moved out (the evidence is unclear as to exactly when), and by 1992 one of the apartments was occupied by the Appellant's daughter, who works nearby, and the other by Mrs. Nicholson's mother, who was infirm and had previously lived in a seniors' home. Although the evidence is scant, it appears that both of them paid rent at about the market rate.

3 The purchase price of the triplex in September 1984 was $45,000. It was paid for with the $15,000 equity which the Appellant and his wife had built up in their previous home, and a $30,000 mortgage with an interest rate of 171/2% per annum. Over the next several years the mortgage was replaced a number of times. In December 1985 it was increased to $40,000, at a rate of 12% per annum; in November 1988 it was further increased to $75,000 at 11.75%; in June 1991 it was increased again, this time to $85,000 at 11.53%; this last mortgage was renewed in January 1994 at a rate of 7.75% per annum, and by the date of the trial in January 1998 the principal outstanding had been reduced to $53,000. The Appellant testified that these increases in the mortgage had all been to provide funds for necessary capital expenditures on the property which he and his wife had not foreseen at the time they bought it. These included a new roof, a new septic system, and a new well. There was little evidence about the cost of these items, but counsel for the Crown did not challenge the Appellant's statement that he took no money from the mortgage advances, except so far as necessary to make these improvements of a capital nature.

4 The Appellant's position is that when he and his wife bought the triplex it was a viable business proposition from which they could expect to derive profits, and that this changed only because of the capital expenditures which required them to increase their mortgage debt by as much as $55,000 by June 1991. He testified on cross-examination that they had a plan for the property which would have seen it produce a profit; however he gave no evidence of what that plan was. Nor was any income statement, pro forma or otherwise, for the early years put into evidence. The Reply to the Notice of Appeal sets out in paragraph 9(c) the history of gross rental income and losses claimed by the Appellant in relation to the property over the eight years from 1987 to 1994, and these were not disputed.

Year	Gross rental income	Net Rental Loss
1987	$8,842	$5,622
1988	$9,090	$1,038
1989	$5,805	$5,920
1990	$7,610	$5,758
1991	$7,950	$5,542
1992	$6,575	$9,708
1993	$7,600	$7,447
1994	$7,040	$5,752

1995	$8,040	$3,665
1996	$8,440	$1,228 profit before CCA

5 The losses for the eight years from 1987 to 1994 total $46,787. The Respondent relies on this history of losses as demonstrating that there has never been a viable business with the potential for profit, and certainly not in the years under appeal. The Appellant says that if he had not been subject to the misfortune to have had to make very large and unanticipated capital expenditures then there would have been profits prior to the years under appeal.

6 It is clear from the loss claims made by the Appellant in his income tax returns that he has been prone to calculate his losses in a way that tends to maximize them to a degree not warranted by the facts. During the years 1992 to 1996, which are the only years for which the income statements are in evidence, he consistently attributed one-third of the expenses for insurance, mortgage interest, taxes and utilities to the personal use of his family, and two-thirds to the rental units. No floor plan of the whole building, or measurements of the various living areas, was put into evidence. When asked on cross-examination about the relative areas of the personal use and rental parts of the building, the Appellant first said that it was about 50% to 60% personal living area. He later said it was 50%. Later still, he said that it was really 33.3%, as applied by him in filing his returns, because one tenant, his mother-in-law, was permitted some occasional use of a stairway and passageway to have access to the laundry room, and use of the laundry room itself, three times per week, and occasional use of a stairway and hallway for ingress and egress through the family's living quarters, also about three times per week. These areas, used by her only occasionally, amount to some 200 square feet. The whole building is about 4,000 square feet. The occasional common use of some 5% of the building does not in my view significantly alter the personal to business use ratio; certainly it does not reduce it from 50% to 33.3%. I find that the appropriate ratio in which to attribute these expense items is 50% to the personal use of the Appellant's family, and 50% to the two rental units.

7 In each of the years from 1992 to 1996 the Appellant claimed to be entitled to reduce his other income by the full amount of the losses, as calculated by him, even though he testified that the house was owned jointly by him and his wife. He offered no explanation for this.

8 In his direct examination the Appellant testified that his purpose in buying the triplex was to provide additional income to supplement his retirement income. On cross-examination he was confronted with the answers that he had given to a questionnaire some two years earlier. One question and answer therein are as follows:

4) What was the initial purpose of acquiring the property?

We moved to the bigger house to accommodate all our family members. Husband, wife and four children. We also hoped that the rent from the two apartments would help with our mortgage payments.

9 During argument I permitted the Appellant, who was represented by an inexperienced agent, to re-open his case to give the evidence about shared use of part of the premises to which I have referred above. That evidence is totally inconsistent with his statement in the questionnaire that no facilities are shared between the landlord and the tenant. He attempted to explain these inconsistencies by saying that the questionnaire had been completed by his wife, and that he had signed it without reading the answers. At that point his agent, to his credit, informed me that the answers to the questionnaire had been completed by him in his office while the Appellant sat across from him giving him the information. The Appellant then signed it, below the words:

I hereby certify that the information given in this questionnaire and in any documents attached is true, correct and complete in every respect.

10 For these reasons, and because of the degree to which he strove to be self-serving in his answers, I have little confidence in the Appellant's evidence.

11 Counsel for the Respondent argued that I should view this case as being one involving a strong personal element, and therefore subject to the closest of scrutiny as to the bona fides of the alleged business, in accordance with the decision of the Federal Court of Appeal in Tonn v. R..[FN1: <p>(1995), 96 D.T.C. 6001 (Fed. C.A.), at 6009 -6010.</p>] Certainly the question and answer which I have quoted above as to the intention of the taxpayer at the time of purchase gives some support to that view. So too does the fact that the tenants, during the years under appeal, were both immediate family members. However, the building is a triplex, and, as I understand it, was originally built as such. The original tenants were unrelated to the Appellant. Nor do I attribute great importance to the Appellant's answer to the question as to intention in the questionnaire to which I have referred. I very much doubt that either the Appellant or his agent would have appreciated any significant difference between making a profit and hope that the rent would help with the mortgage. On balance, I believe it is proper to view this as a case where the Appellant's subjective intention was to make a profit. The question which remains, then, is whether or not, applying the objective criteria to which authority directs me,[FN2: <p><em>Moldowan v. R.</em>(1977), 77 D.T.C. 5213 (S.C.C.), at 5215 ;<em>Landry v. R.</em>(1994), 94 D.T.C. 6624 (Eng.)(Fed. C.A.) per Décary J.A. at 6626 and the cases cited there.</p>] the Appellant could be said to have had a reasonable expectation of profit at the appropriate point in time.

12 An operation may begin with a reasonable expectation of profit, and yet later prove, after an appropriate start-up period, to be so unsuccessful that it can no longer be said to have a reasonable expectation of profit, with the result that it can no longer be said to be a business, and therefore a source of income, for the purposes of section 3 of the Act. Similarly, an operation with no potential for profit, as initially structured, may acquire that potential through as a result of changed circumstances. This is such a case.

13 Unfortunately, I have little evidence before me as to profitability in the early years. However the known facts do demonstrate that in 1987 the loss reported of $5,622 greatly exceeds the total amount of interest that could be attributed to the rental units, which is approximately $2,400. The loss reported for 1991, $7,950, considerably exceeds the total attributable mortgage interest of approximately $4,650 in that year. These are the first and the last of the years prior to the years under appeal for which some data are available.

14 I turn now to the years under appeal. The Appellant attributes his losses in these years to the high interest costs arising out of the capital expenditures in earlier years. The reported losses are also inflated by his attribution of 66.6% of the expenses to the rental units. However, when the losses are recalculated on the basis of an apportionment of 50% to the rental units, the following picture emerges for the years under appeal, and the two years thereafter:

Year	Reported loss	Adjusted loss	Interest	Adjusted loss net of interest
1992	$9,708	$6,543	$4,713	$1,830
1993	$7,447	$4,302	$4,587	$ 285 profit
1994	$5,753	$3,224	$3,169	$ 55
1995	$3,665	$2,822	$2,567	$ 255
1996	$1,228 profit	2,443 profit	$2,337	$4,780 profit

15 This demonstrates that the Appellant's rental operation did not have a potential for profit as it was structured prior to the reduction of the mortgage interest rate to 7.75% in January 1994. The inability to show a profit in earlier years is not attributable simply to the fact that the mortgage principal was greatly increased between 1984 and 1991. Even if the Appellant had paid no interest at all, he would have seen no profit until 1996, except for $285 in 1993, which takes no account of capital cost allowance.[FN3: <p>see<em>Moldowan v. R.</em>(1977), 77 D.T.C. 5213 (S.C.C.)per Dickson J. at 5215.</p>] Real profit from these units was realized for the first time in 1996 a fact which I find is attributable to two factors which could not be foreseen prior to 1994. One is a significant increase in the gross rental income in each of the years 1995 and 1996. The other is the renewal of the mortgage in January 1994 at 7.75% per annum, a decrease of almost 4% from the prior years, and almost 10% from the original rate. I find that a reasonable expectation of profit emerged in this case for the first time in January 1994, and that the Appellant is therefore entitled to take his losses from the property into account in computing his income for that year only.

16 The appeals for the taxation years 1992 and 1993 are dismissed. The appeal for the taxation year 1994 is allowed; the assessment is referred back to the Minister for reconsideration and reassessment on the basis that in computing his income under section 3 of the Act, the Appellant is entitled to take into account his losses from the rental property, not as they were reported by him, but as properly ascertained on the basis that 50% only of the expenses relating to insurance, mortgage interest, property taxes, utilities, garbage removal, snow plowing and lawn mowing are attributable to the rental operations, and that 50% only of the net loss for that year, so calculated, is allocable to the Appellant, the other 50% being allocable to his spouse as co-owner of the property.