Date: 20010501
Docket: 2000-4279-IT-I
BETWEEN:
JOHN L. DESROCHES,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Miller, J.T.C.C.
[1]
This is an appeal pursuant to the Informal Procedure by John
Desroches of the Minister's reassessments for the 1996, 1997
and 1998 taxation years. In those reassessments of September 9,
1999, confirmed by Notice of Confirmation of July 20, 2000, the
Minister disallowed the deduction of rental losses claimed by the
Appellant for 1995, 1996 and 1997 in the amounts of $3,075.98,
$2,362.43 and $520.12.
ISSUES:
[2]
The Respondent, in the Reply to the Notice of Appeal, set forth
the issues as follows:
a)
whether the Appellant had a reasonable expectation of profit from
the rental of the Property 1996, 1997 and 1998 taxation
years;
b)
whether the expenses disallowed by the Minister in respect of the
Property were incurred by the Appellant for the purpose of
gaining or producing income from a business or property; and
c)
in the alternative, whether the disallowed expenses were
reasonable in the circumstances.
[3]
The Respondent goes firstly to the reasonable expectation of
profit ("REOP") test as being the premier issue - the
Moldowan[1]
test. Next he turns to section 18(1)(a) of the Income
Tax Act ("Act") asking whether the expenses
disallowed were incurred for the purpose of gaining or producing
income. Finally, he falls back on section 67 of the Act -
the reasonableness test. In reassessing the Appellant the
Minister disallowed rental losses to be claimed against other
income. This, I suggest can be viewed either as allowing the
Appellant's expenses up to the amount of the rental revenue
(but no more), or disallowing all of the Appellant's
expenses, while, at the same time, recognizing none of the rental
revenue as a source of income. By framing the issues as he has
(referring to disallowance of expenses), I was led to an initial
conclusion he was disallowing only those expenses in excess of
the rental revenue, implying he was allowing the deduction of
expenses up to the amount of the rental revenue. Counsel for the
Respondent disabused me of that notion.
FACTS:
[4]
The Appellant purchased 4 Chilcot Avenue, Toronto for $165,000 in
1992 as his principal residence. He acquired a mortgage at the
time. In 1995 he separated from his wife and, as he described, in
order to afford to keep his home he determined to acquire
tenants. He advertised by putting up a notice at his place of
work. A co-worker responded and moved in until the end of 1997,
at which point the Appellant's brother became a tenant and
remained so for all of 1998. The tenant's space consisted of
the basement area, being a living room, bedroom and bar with a
utility room. This space represented approximately 30 percent of
the total liveable space in the house. The Appellant indicated
the tenant also had the use of the kitchen and bathroom upstairs.
The rent charged was less than fair market value as the Appellant
was anxious to rent as quickly as possible as he needed the
funds. Both the co-worker, and subsequently the brother needed a
place due to their own marital difficulties. The following is a
summary of the revenue and expenses for the years in
question:
|
|
1996
|
1997
|
1998
|
|
Revenue
|
$4,800
|
$4,800
|
$4,800
|
|
Expenses (all at 50%)
|
|
|
|
|
Insurance
|
190.50
|
218.50
|
174.84
|
|
Interest
|
4,968.09
|
4,580.03
|
2,801.42
|
|
Maintenance
|
475.00
|
250.00
|
200.00
|
|
Property taxes
|
995.45
|
1,015.95
|
1,026.66
|
|
Utilities
|
1,246.94
|
1,097.95
|
1,117.20
|
|
|
7,875.98
|
7,162.43
|
(5,320.12)
|
|
Loss
|
(3,015.98)
|
(2,362.43)
|
(520.12)
|
The losses in 1994 and 1995 were $3,531 and $2,960
respectively.
[5]
The Appellant kept no receipts for any of his maintenance costs.
There was no written lease between the parties, as it was an
informal arrangement according to the Appellant. Once the
Appellant got his "head above water" he ceased the
rental arrangement. This occurred in late 1999 or early 2000.
APPELLANT'S POSITION:
[6]
The Appellant's position is that the expenses incurred
resulting in the losses claimed were legitimate, reasonable
expenses permitted pursuant to section 18(1)(a) of the
Act. Representing himself and not having had the
scholarship of the plethora of case law on this subject, this is
an earnest and appropriate understanding of our tax laws. He had
a property; he received income from it; he incurred expenses on
it; half of these expenses he claimed were not personal but were
incurred to earn that income; this resulted in a loss which he
claimed.
RESPONDENT'S POSITION:
[7]
The Respondent's position is that:
1.
The Appellant did not have a reasonable expectation of profit and
consequently, relying on Moldowan, no source of income. He
suggested this does not subject the rental revenue and expenses
to the purview of the Act.
The next three positions appear to presume the rent is subject
to the Act but the expenses over and above the rental
revenue are not deductible.
2.
The rental expenses which constitute the losses were not incurred
for the purpose of producing income within the meaning of section
18(1)(a).
3.
The rental expenses which constitute the losses were personal or
living expenses (section 18(1)(h)).
4.
The rental expenses which constitute the losses are not
deductible against other income as they are unreasonable (section
67).
Finally, the Respondent presents an argument in the
alternative. In the event I find the Appellant had a rental
operation, by which I presume he means "business", as
clearly the Appellant received rent, the rental expenses allowed
should be prorated to 30 percent of the total expenses. A
mathematical calculation on this basis would result in the
Appellant having a small taxable income in 1998. The Respondent
suggested that if I find this constituted a business it is not
the intention of the Minister to tax the Appellant on this small
amount, but rather I should simply dismiss the appeal. This
alternative argument I find intriguing as it suggests to me that
only if I find there is a rental operation or business do I need
to consider the deductibility of actual expenses at all. It
follows that it is indeed open to interpret the Minister's
reassessment on the basis that the losses, being a calculation of
both revenue and expenses are not subject to the Act. The
Respondent's counsel in fact confirmed this approach.
ANALYSIS:
[8]
The Respondent's argument appears to take three forms. First,
there is no reasonable expectation of profit, therefore no source
of income, therefore the appeal should be dismissed. Second,
there is no reasonable expectation of profit, but the disallowed
expenses (i.e. the losses) were not incurred for the purpose of
producing income but were personal or living expenses and also
unreasonable so should not be allowed. Third, if there was a
reasonable expectation of profit the expenses should be limited
to 30% of the total expenses.
[9]
With respect to the first argument, I look to Moldowan as
referred to in Mastri v. Her Majesty the Queen, 97 DTC
5420, as follows:
First, it was decided in Moldowan that in order to have
a source of income a taxpayer must have a reasonable expectation
of profit. Second, "whether a taxpayer has a reasonable
expectation of profit is an objective determination to be made
from all of the facts" (supra at 485-86). If as a
matter of fact a taxpayer is found not to have a reasonable
expectation of profit then there is no source of income and,
therefore, no basis upon which the taxpayer is able to calculate
a rental loss.
[10] If
instead of referring to a source of income, reference is made to
a source of profits, it becomes more readily apparent how we can
accept the tenet that without a reasonable expectation of profit
there is no source of income. If there is no source of income we
need not concern ourselves with sections 18(1)(a) and
(h) or section 67. We have taken the "rental
arrangement" outside the basic inclusionary section of the
Act, section 3. To find otherwise in a situation where
there is no REOP, that is to find the Minister's assessment
is tantamount to a finding that expenses are allowed up to the
amount of rental revenue, is faulty logic. I limit this analysis
to income from property as different considerations come to play
in a situation of income from business. This was in fact alluded
to in Mastri, at page 5422:
For the sake of doctrinal purity, I should also point out that
a distinction must be drawn between the determination of whether
a taxpayer's source of income is from a business as opposed
to a property. I may own a rental property but whether I carry on
a business in regard thereto is a distinct legal issue giving
rise to other tax consequences not relevant to the cases under
review. Thus, strictly speaking it is inappropriate to speak of
business expenses incurred in relation to a rental property
unless, of course, the taxpayer's endeavours are regarded in
law as a business. In any event, it is helpful at this point to
set out the specific findings of law articulated in
Moldowan.
[11] The
Federal Court of Appeal did not carry on with this line of
distinguishing between business and property for purposes of the
REOP test. The Court did go on to explain Moldowan as I
have already set out above. The distinction might well be however
that income from property has a lower threshold for determining
if it constitutes a source of income. That threshold may be an
application of the REOP test; whereas to find income from
business one only applies the REOP test in light of the
definition of business as set forth in the Act and as
cautioned by the recent cases of Tonn and
Mastri.
[12] So, I
will deal with the REOP test. I find the Appellant did not have a
reasonable expectation of profit for the following reasons. From
1994 to 1998 there were continual losses. Upon any objective
assessment of potential revenue versus expense, it is difficult
to see how he could have generated a profit. As the Appellant
acknowledged, to keep the house he needed to generate some income
quickly, and therefore rented at less than fair market value. If
he wanted to keep the house he had to defray the costs of his
personal residence. Clearly there is a strong personal element.
There was no formal plan or projection provided. There was no
written agreement; there was simply, as Mr. Desroches put it, an
informal arrangement. Once his needs were met and he attained
some financial security there would be no further need to have a
tenant, which is the position he is now in. There was no rental
operation or business as such, but an informal arrangement with a
co-worker and a brother. There was no reasonable expectation of
profit.
[13] To be
clear this is not a finding of expenses being allowed up to the
amount of revenue but a finding there is no source of income
subject to the Act. Had the Appellant only claimed 30
percent of his expenses he would have had a small profit in 1998.
I do not find this is sufficient to categorize the undertaking as
having had a reasonable expectation of profit such as to
constitute it a business and a source of income within the
meaning of Moldowan.
[14] With
respect to the second argument, if I am correct in my analysis it
is unnecessary to answer questions 2, 3 and 4 of the
Respondent's position. However, if there is what I will call
a mid-position (a finding of no REOP but a requirement to still
analyze the nature of the denied losses), then I find the
expenses over and above the rental revenue were personal or
living expenses within the meaning of section
18(1)(h).
[15] Having
found there was no reasonable expectation of profit I need not
address the Respondent's third argument limiting expenses to
30 percent.
SUMMARY:
[16] It
appears there are three routes to follow in an analysis of a case
of the deductibility of rental losses against other income where
there is a personal element involved:
1.
Determine there was no reasonable expectation of profit and
therefore no source of income to get past section 3 of the
Act. The expenses to consider in this approach are not the
actual expenses claimed but an objective assessment of what
expenses would be reasonable in the circumstances. Assess the
reasonable expectation of profit on that basis.
2.
Determine there was a reasonable expectation of profit. In this
approach one would then review the actual expenses and determine
their legitimacy for deduction considering sections 9(1), 9(2),
18(1)(a) and (h) and 67. The result may well be a
loss available for deduction against other income. (see Narine
v. Her Majesty the Queen, [1995] 2 C.T.C. 2055)
3.
Find there is no reasonable expectation of profit and allow the
deduction of expenses only up to the amount of the rental income.
This mid-position requires some analysis of the disallowed
expenses (the losses) to determine if they can be denied on the
basis of section 18 or section 67. While I find such an approach
not as conceptually appealing, it appears to have served as a
useful practical guide to provide certainty and fairness in
similar cases. Applying either the first or third approach yields
the same result in the situation at hand and logically always
will in the case of rental losses. It may though provide a
different result in the event of an unexpected profit. It could
also have some ramification as to how a taxpayer files a return;
under the first approach the return would show no rental revenue
or expense, while following the third approach the return would
provide both.
[17] I find no
reasonable expectation of profit in this case for the reasons
mentioned above and dismiss the appeal. I do so on the basis of
the first approach; that is, the rental arrangement does not
constitute a source of income within the meaning of the
provisions of the Act.
[18] The
appeal is dismissed.
Signed at Ottawa, Canada this 1st day of May, 2001.
"Campbell J. Miller"
J.T.C.C.
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