Date: 20011010
Docket: 2000-2416-IT-I
BETWEEN:
KUMARA S. RACHAMALLA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor
Judgment
Campbell, J.
[1]
These appeals are from assessments for the 1990, 1991, 1992 and
1993 taxation years.
[2]
The issue is whether the Appellant had a reasonable expectation
of profit from his rental activities in respect to two properties
that would entitle him to deduct rental losses and carrying
charges in the 1990 to 1993 taxation years.
[3]
The Minister relied on the following assumptions set out at
paragraph 13 of the Reply to the Notice of Appeal as follows:
(a)
the Appellant is a real estate agent and purchased the following
two properties (the "Properties"):
Property #1
1 York Quay, 77 Harbourfront, Suite 2001, Toronto, Ontario.
The property was owned equally by the Appellant and Nandakumar
Chari.
The Purchase agreement was signed on October 26, 1986 and the
occupancy date was December 10, 1990.
The purchase price was $227,900.00 with a down payment of
$77,600.00.
A vendor took back the mortgage of $150,300.00 at 10 3/4%.
The property was rented out since April 1990.
Property #2
120 Promenade Circle, Apt. 907, Thornhill, Ontario.
The property was fully owned by the Appellant.
The Purchase agreement was signed on January 18, 1989 and the
occupancy date was December 10, 1990.
The purchase price was $288,250.00 with a down payment of
$98,250.00 and a mortgage of $190,000.00 at 13%.
The property was rented out since January 1991;
(b)
the Appellant claimed rental losses in respect of two Properties
as shown in attached Schedule A;
(c)
the total interest expenses consisted of the mortgage interest
claimed on rental statements, and the investment carrying charges
claimed under line 221 of the T1 returns;
(d)
the rental income for the years under appeal did not cover the
interest charges as the Properties were fully financed. The
deposit amounts for the purchase of the Properties were borrowed
from the Appellant's personal line of credit;
(e)
the Appellant's rental and cash flow projections on the
Properties were unrealistically optimistic as the interest
expenses were understated and no capital cost allowance was
included;
(f)
rental expenses in excess of the amounts allowed by the Minister
for the Properties were not incurred for the purpose of gaining
or producing income from a business or property, but were
personal or living expenses of the Appellant;
(g)
the rental activities in the Properties were not carried on with
a reasonable expectation of profit;
(h)
in the alternative, the expenses claimed for the Properties in
excess of the amounts allowed by the Minister were not reasonable
in the circumstances.
[4]
The Appellant obtained an MBA from the University of Toronto in
1969. He worked as an investment advisor with a number of firms
until he was hired as a policy advisor by the Ontario government.
He remained with the government until his retirement in 1994. In
1986 he became a licensed real estate agent and broker. He sold
real estate part time and also taught courses in real estate
licensing at a community college.
[5]
Mr. Rachamalla purchased his first rental property, known as the
Pony Mill property, around 1986 in the Scarborough area, in
partnership with a Mr. Chari. This property was sold several
years later at considerable profit. It was reported as a capital
property.
[6]
In late 1986, the Appellant again in equal partnership with Mr.
Chari, purchased another property known and referred to here as
the York Quay property. This property was a luxury downtown
condominium unit in the Harbourfront area of Toronto. A parking
unit was also acquired for this unit. The Appellant's
evidence was that he purchased it for its location and its
ability to attract good high-end tenants prepared to pay a higher
rent.
[7]
York Quay was under construction at the time of purchase. With
four years of construction delays, the unit was not rented until
February 1990. The cost of the unit plus parking area was
$227,900.00. By September 1989, the Appellant and his partner
owned 25% of the unit, having made numerous deposits to the
vendor amounting to $57,080.00. They paid the further sum of
$20,520.00 in February 1990, the closing date. The Appellant
testified that his one-half share of these deposits came from his
personal funds. He also stated that it was always their intention
to operate this unit as a rental property. Initially the unit was
leased at the anticipated high rental rate. The rental market in
Toronto in the early 1990s, however, experienced a sudden
dramatic decline with vacancy rates increasing.
[8]
As soon as the Appellant acquired ownership and occupancy of the
unit he attempted to rent it by listing and advertising with
TREB, the Toronto Real Estate Board, to attract a quality tenant.
The cost to do so was one month's rent. The unit was
eventually rented, although for several months only in 1990. The
unit was always rented to arm's length tenants. However the
anticipated higher rental income could not be maintained due to
the collapse in the Toronto real estate market in the early
1990s. With the construction delays of four years, maintenance
fees for the unit and property taxes had increased. Mortgage
interest rates had also increased substantially during this same
period.
[9]
At the date of closing, in 1990, the Appellant financed the
balance of the purchase price ($150,300.00) through a vendor
take-back mortgage. The monthly payments of over $2,000.00
included interest payments, maintenance fees, parking lot fees
and estimated taxes. In March or April of 1991, the property was
re-financed with Mutual Life. At this point the Appellant and his
partner began an aggressive pay-down plan with respect to this
mortgage. Short term mortgages were taken, generally one-year
periods, which provided lower interest rates. Various lump sum
payments were made and in 1994 the Appellant commenced weekly
mortgage payments instead of monthly, again to accelerate
pay-down of the mortgage. This again assisted in accelerating
pay-down of the mortgage. In the mid 1990s the Appellant
successfully negotiated the property taxes to a lower rate. In
1997 the mortgage was transferred to the Bank of Montreal to
obtain a preferred rate of interest. While continuing to reduce
the outstanding principal, the rental incomes were successfully
increased.
[10] In 1996
this property began to show a profit and continues to do so
today. The amount of profit has increased each year since 1996
from approximately $800.00 to over $6,000.00 in the year 2000.
The mortgage was reduced from $155,000.00 in 1991 to $81,496.00
by the end of the year 2000. As pointed out by Appellant's
counsel, this reduction represents a 50% cut in the mortgage
balance within nine years during some of the worst real estate
market conditions the Toronto area had experienced.
[11] Very
detailed monthly logs or ledgers were maintained throughout the
years. It is quite apparent from both the Appellant's
evidence and the documentation provided at the hearing, that the
bookkeeping system of income and expenses for this property was
methodically maintained.
[12] In 1995,
just two years after the Appellant was assessed, the gross rental
income exceeded the projections that the Appellant made in 1986
when he first made a deposit on this property. The reported
profits have increased significantly in each year after 1995.
[13] A second
property was acquired in 1989, referred to as the Promenade
property. It was purchased by the Appellant alone and was located
in the North end of Toronto, an area experiencing great growth at
that time. Again it was a luxury condominium which was expected
to attract a higher calibre of tenant. At the time of purchase
the rental market was rising and the Appellant's evidence was
that he thought the trend would continue. According to the
Appellant, he purchased this property to diversify his real
estate investments, as this unit was located in an entirely
different area of the city from the York Quay property.
[14] The
Promenade property was under construction at the time of purchase
in 1989. According to the evidence of the Appellant, in what was
a rising real estate market, he anticipated reselling or flipping
the property within one year of completion of the unit. However
by the time the unit was ready for occupancy, the market of the
early 1990s was in a state of collapse. The Appellant was forced
to re-think his plans and as he put it: "I decided to rent
the property and minimize the costs and minimize the damages so
that I would be able to maintain the property". The fair
market value of the property had declined to below its original
purchase price.
[15] The
purchase price of this property was $288,250.00, including
parking. The Appellant paid deposits totalling $65,000.00 by
October 1990 through his personal funds. At closing, an
additional payment of $33,000.00 was made. Because of the market
conditions, the Appellant listed the property for both rent and
sale. Certainly the documentation produced supports the
Appellant's evidence that when he purchased the property, he
intended to resell quickly for profit. And the evidence is clear
that this property was not 100% financed. Exhibits showed that
the property was listed for sale in October 1990 for $289,900.00,
again in August 1998 for $202,900.00 and in 1999 for $200,000.00.
If he had been able to sell at a profit, he would have done so.
This was supported by both the documentation and oral
evidence.
[16] To assist
in renting the property he again enlisted the services of TREB as
he had done for the York Quay property. He screened tenants to
obtain the best quality tenant, charged market rents which he
increased regularly and followed an aggressive pay-down plan. He
gave evidence that when the market improved he would sell but
until then he had to rent the property and maintain it in a
saleable condition. In late 1990, a vendor take-back mortgage for
$190,000.00 was arranged at an interest rate of 13%. Rental of
the unit commenced in 1991 and was always with arm's length
tenants. In 1992 the vendor take-back mortgage was retired but
due to the market conditions, the Appellant could not arrange for
a mortgage for 75% of the purchase price to replace the vendor
take-back mortgage being retired. The market value of the
unit had declined according to the Appellant to $150,000.00 or
less. He arranged a first mortgage in the amount of $120,250.00
with Laurentian Bank and a second mortgage in the amount of
$45,000.00 with Beneficial Trust. In 1993, the second mortgage to
Beneficial was retired and replaced with a private, arm's
length loan (the Padmini loan), arranged through the
Appellant's solicitor. This allowed the Appellant to reduce
the monthly payments by approximately $150.00. In addition
pre-payments could be made on the loan without penalty.
This loan was retired in the fall of 1994, one year after the
auditor's review. In the same year, the first mortgage to
Laurentian was discharged and replaced with a mortgage to the
Bank of Montreal. Accelerated weekly payments were commenced and
the outstanding balance was reduced from $117,000.00 in 1994 to
$94,808.00 in 2000. The original mortgage of $165,000.00 in 1990
had therefore been reduced by over 50%.
[17] The
Appellant testified that his deposits on the Promenade property
came partly from the sale proceeds of the first property the
Appellant purchased in the 1980s known as the Pony Mill property
and partly from a personal line of credit. As the interest rates
on lines of credit in the early 1990s were so high, the Appellant
re-financed his personal residence to pay off this line of credit
and accommodate financing requirements for the two properties.
When he re-financed his residence, the mortgage was increased
from $140,000.00 to $270,000.00.
[18] Between
1990 and 2000, the Appellant significantly reduced carrying
charges on the Promenade property according to spreadsheets
prepared by the Appellant for the auditor. And by 2000 the payout
on the mortgage against his personal residence had been reduced
from $270,000.00 to $141,324.51.
[19] Again
detailed logs were kept on a monthly basis regarding this
property. The oral evidence of the Appellant was completely
substantiated by the volumes of bank statements, summaries and
other documentation introduced by the Appellant's counsel.
The Promenade property began to show a profit by 1996, an amazing
feat given the market conditions of the early 1990s and the
rising interest rates. In addition the Appellant was the owner of
a property he originally intended to sell but was now unable to
do so, as the market value had fallen from $288,000.00 to
$150,000.00 or less, shortly after the purchase.
[20] I commend
both counsel in this case for their presentations and summations.
Both presented clear and concise reviews of the case law in this
area beginning with the Supreme Court decision in Moldowan v.
The Queen, [1978] 1 S.C.R. 480; 77 DTC 5213 (S.C.C.).
The principles which have emerged from the many cases in this
area were clearly and concisely summarized by Associate Chief
Judge Bowman of this Court in a recent decision, Donyina v.
The Queen, [2001] T.C.J. No. 456. Reproduced from paragraph 9
of Judge Bowman's decision, they are as follows:
[9] I
shall not quote from these cases or analyse them at length. It
is, I think, sufficient to summarize some of the principles that
they appear to establish.
1.
Where there is no personal element the REOP test should be
applied sparingly (Tonn, Keeping,
Bélec and Walls). The absence of a personal
element does not establish conclusively that the REOP principle
cannot be invoked but such an absence is a factor that carries a
great deal of weight (Mastri).
2.
The Minister or the court should not, with the benefit of
hindsight, second-guess the business acumen of a taxpayer who
embarks upon a business venture in good faith (Keeping,
Tonn, Nichol, Kuhlmann, Bélec
and Smith).
3.
The fact that a business or property is 100% financed is not in
itself a reason for applying the REOP principle (Milewski,
Mohammad and Saunders).
4.
A taxpayer should be allowed a reasonable period of time to get
the business established (Keeping). Such a period will
vary with the circumstances and may well be lengthy
(Milewski).
5.
The REOP principle should not be invoked as a substitute for
analysis. Before invoking REOP the assessor should examine the
expenses to determine whether they are reasonable or for any
other reason not deductible (Smith, Costello and
Cipollone).
6.
For an expectation of profit to be reasonable it has to be not
"irrational, absurd and ridiculous"
(Kuhlmann).
7.
The fact that an investment or a business is motivated in part by
tax considerations is not relevant in determining whether there
is a business, nor is tax motivation in itself relevant in
determining the deductibility of expenses if a business exists
(Stubart Investments Limited v. The Queen,
84 DTC 6305) unless of course the Minister chooses to
invoke the general anti-avoidance rule in section 245, in
which case we are into a fundamentally different ball-game.
8.
The initial question where losses are claimed and denied is
whether they are personal or living expenses, the statutory
definition of which includes the REOP test. If they are not, the
REOP test must be applied with extreme care and the question
becomes "Is there a business?" The existence of REOP is
only one factor in that determination (Kaye).
9.
Reasonableness operates both in the context of the existence of a
business, where section 67 disallows the deduction of
expenses to the extent that they are unreasonable, and also at
the liminal stage of determining whether there is a business
(Kaye).
10.
If what is ostensibly a rental property was acquired and held in
the course of an adventure in the nature of trade and it was
reasonable to expect a profit on the resale the losses
(i.e. carrying costs net of rentals received) should not
be disallowed on the basis of REOP (Roopchan). The court
should however examine with some care an ex post facto
declaration that property that was carried for some years at a
loss is part of a speculative venture in which the motive was
resale at a profit. This is not something that one would expect
someone readily to admit if the property were sold at a
profit.
11.
If the taxpayer has several rental properties, some yielding a
profit and some a loss, it is improper to apply REOP to the
losing properties and ignore the profitable ones. The entire
investment picture should be considered (Smith).
12.
When to start a business and when to abandon it are business
decisions in which neither the taxing authorities nor the court
should intervene (Nichol). Nonetheless if losses go on
being incurred year after year for an inordinate length of time
sooner or later one has to apply what I shall call the
"Enough is enough" principle and decide that what might
have been a viable business has, with the efflux ion of time,
became hopeless and the best thing to do with it is to give it a
decent burial. Nonetheless, a businessman's judgement to
maintain a business must be treated with great respect.
[21] When I
apply those principles which are applicable to the facts of this
case, I can only conclude the obvious — that the Minister
was simply incorrect in applying this test to the two rental
operations belonging to the Appellant. The years in question are
clearly start-up years for both properties. Both the York Quay
and Promenade properties have been in a significant profit
position since 1996. In fact the trend of increasing incomes and
decreasing expenses was clearly established as early as 1994.
Given the state of the Toronto real estate market in the early
1990s and the soaring interest rates, the Appellant's efforts
turned both properties into profitable operations in a remarkably
short duration. He established and pursued an aggressive business
plan to pay down the indebtedness against both operations. His
actions were those of an astute businessman. His plan was
methodical and well structured. There was nothing haphazard in
his approach to the unforeseen intervening circumstances which
arose in the market shortly after his purchases. With the
Appellant's extensive background in the real estate market,
his projections in the 1980s at the time of purchase were both
reasonable and realistic. They were based on market conditions at
that time. However, the market changed, vacancy rates changed,
interest rates increased as did maintenance fees and property
taxes. All of these factors were beyond the control of the
Appellant who then had to re-group and re-think his original
plans. He was able to do so and shortly after the years in
question the properties started to show profit.
[22] The
projections made in 1986 with respect to the York Quay property
were realistic and valid in relation to the market rates and
conditions as they existed in 1986. The Appellant could not have
predicted the drastic changes in interest rates and market
conditions that were to occur in the early 1990s. The attempt by
the Respondent to somehow show that these 1986 projections were
unreasonable is a classic example of the use of hindsight by the
Minister to second-guess the business decisions of the
Appellant.
[23] Where
there is no personal element, the case law is clear - the
reasonable expectation of profit test is to be used sparingly.
There was no personal element here. The Appellant clearly
operated these properties as businesses. The facts so clearly
point to the commerciality of the operations that to draw any
other conclusion would be ludicrous. The Appellant used his
expertise in the Toronto real estate market to search out the
best locations, maximized exposure by paying an entire
month's rent to advertise for tenants through the specialized
Toronto Real Estate Network Board, screened tenants personally,
kept the units rented during extremely difficult market
conditions, established and followed an aggressive mortgage
pay-down plan, cutting mortgages to half by the end of 2000,
successfully appealed property taxes and reduced expenses. In
addition the properties were not fully financed as stated in
assumptions in the Reply. Some of the profit from the Pony Mill
property sale was used as a deposit on the Promenade property and
in addition the Appellant had alternate sources of financing. It
also appeared from the auditor's evidence that she may have
incorrectly assumed that the properties were 100% financed. And
throughout the entire period meticulous records and logs were
kept.
[24] To borrow
a phrase used by Appellant's counsel - "If this
isn't a business, then I don't know what is?" In
Respondent counsel's submissions, she argued that
"...there's no evidence of a concerted plan to make
significant payments against the principal". To call this
anything but a concerted plan or to suggest there was anything
but significant reductions in all indebtedness associated with
these operations is to have either slept through the presentation
of the facts or to have blatantly ignored them.
[25] The
Appellant made an alternative argument that if I concluded there
was no reasonable expectation of profit for the Promenade
property it could be characterized as an adventure in the nature
of trade. I need not make any finding in this respect as the
Respondent has been unsuccessful in persuading me that the
Promenade property was so heavily financed that there could be no
reasonable expectation of profit. The facts clearly support the
opposite conclusion. His approach to this property was parallel
to the York Quay property. The Appellant's stated intention
at the time of acquisition was for resale, and this was supported
by his later actions in listing it for sale in October 1990 and
again in 1998 and 1999. The financial result would remain the
same for the Appellant as he would still be entitled to deduct
all carrying costs, including rental losses, if the property were
characterized as an adventure in the nature of trade. (See
Stremler and Jones v. The Queen, 2000 DTC 1757
(T.C.C.))
[26] The
appeals are allowed and the assessments are referred back to the
Minister of National Revenue for reconsideration and reassessment
to allow the deduction of rental losses and carrying charges with
respect to both properties for the 1990, 1991, 1992 and 1993
taxation years.
[27] If
counsel wish, they may address the issue of costs in writing
within 30 days of the date of the within judgment.
Signed at Ottawa, Canada, this 10th day of October 2001.
"Diane Campbell"
J.T.C.C.
COURT FILE
NO.:
2000-2416(IT)I
STYLE OF
CAUSE:
Kumara Rachamalla and
Her Majesty the Queen
PLACE OF
HEARING:
Toronto, Ontario
DATE OF
HEARING:
June 1 and June 28, 2001
REASONS FOR JUDGMENT BY: The
Honourable Judge Diane Campbell
DATE OF
JUDGMENT:
October 10, 2001
APPEARANCES:
Counsel for the Appellant: A. Christina Tari
Counsel for the
Respondent:
Sointula Kirkpatrick
COUNSEL OF RECORD:
For the
Appellant:
Name:
A. Christina Tari
Firm:
Richler and Tari
Toronto, Ontario
For the
Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
2000-2416(IT)I
BETWEEN:
KUMARA S. RACHAMALLA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on June 1 and June 28, 2001 at
Toronto, Ontario, by
the Honourable Judge Diane Campbell
Appearances
Counsel for the
Appellant:
A. Christina Tari
Counsel for the
Respondent:
Sointula Kirkpatrick
JUDGMENT
The
appeals from the assessments made under the Income Tax Act
for the 1990, 1991, 1992 and 1993 taxation years are allowed and
the assessments are referred back to the Minister of National
Revenue for reconsideration and reassessment in accordance with
the attached Reasons for Judgment.
If
counsel wish, they may address the issue of costs in writing
within 30 days of the date of the within judgment.
Signed at Ottawa, Canada, this 10th day of October 2001.
J.T.C.C.
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