Wright v. R., [1996] 1 CTC 2029 (Informal Procedure)

Sobier J.T.C.C.:— The appellant appeals from the assessments of the Minister of National Revenue (the “Minister” for her 1990, 1991 and 1992 taxation years whereby the Minister disallowed the deduction of rental losses with respect to properties located at 108 Forbes Crescent, Unionville, Ontario (“108 Forbes” and 74 Alderbury Drive, Markham, Ontario (“74 Alderbury”. The appellant elected to have her appeals heard under the informal procedure.

After various assessments and reassessments all of the losses claimed were disallowed.

With respect to 74 Alderbury, the main issue according to the Minister is whether the appellant had a reasonable expectation of profit having regard to the income and expenses relating to that property.

In dealing with 108 Forbes the rental loss arose from the appellant purporting to rent a portion of it to her husband for use in a jointly owned business which was carried on by her spouse. The rent was $6,000 per year for the three years under appeal.

108 Forbes was owned jointly by the appellant and her spouse as their matrimonial home. Although it was jointly owned she deducted all of the rental losses. Very little evidence was lead by the appellant to support her appeal with respect to 108 Forbes. The main thrust of the appeal was toward 74 Alderbury. If the business operated by her spouse was a joint business she did not report any income from that business for the years under question. She included the rent and deducted all of the expenses including capital cost allowance in each year. The appellant has failed to discharge the onus with respect the 108 Forbes issue and accordingly the appeals are dismissed for the years in question on that issue.

74 Alderbury

It was the appellant’s wish together with her spouse that sufficient funds be available for the education of their two children and the two children of her late brother who came to live with the appellant’s family. To this end, the appellant and her spouse planned their financial future. It was discovered that the education fund, funded by insurance, would not be sufficient and therefore it was their intention to diversify their investments so as not only to produce adequate income but also growth. They invested in term deposits, mutual funds, real estate and the business of servicing and sale of heavy duty equipment which Mr. Wright operated from 108 Forbes. In addition, there were investments in raw land in Florida and Jamaica.

Mrs. Wright has had experience as a financial advisor and manager with the Government of Canada in the areas of budgeting, forecasting and financial control. It was this experience which she brought to the question of financial planning for her family. Based upon studies she made, it was decided that the appellant, her spouse together with her sister Norma

M. Edwards, would make an investment in rental property in the Markam area.

In 1987 she began her examination of this question which included a review of the real estate market in the Metropolitan Toronto and surrounding area. She examined many of the problems, such as, mortgage interest rates, geographical locations, projected income and expenses, vacancy rates, builders reputations. She also made enquiries with the local chamber of commerce and industries located in the Markam area in order to ascertain the commercial and industrial growth of the area with its concomitant growth of available tenants.

Mortgage interest expense was one of the expenses uppermost in her mind and to that end she examined the terms and rates offered by several financial institutions. The appellant’s research on interest went further than merely obtaining rates. She also factored into the interest expense the amortization period in order to determine if savings could be made by shortening the amortization period.

As result of their analysis it was decided to purchase a new home to be built which became 74 Alderbury. The purchase price was to be $259,000 with the Wrights contributing $15,000 and Mrs. Edwards, $15,000. The offer was entered into in February 1989. The closing was slated to take place until January 1990. At that time an additional $30,000 cash was to be paid by the Wrights and Mrs. Edwards. However this was not done and funds totalling $230,000 were borrowed against the existing homes of the Wrights as to $130,000 and Mrs. Edwards as to $100,000. The funds were used to complete the purchase. It was Mrs. Wright’s evidence that two first mortgages on the two homes produced a lower interest than a first mortgage on the subject property.

In researching the matter the appellant made certain assumptions which according to her evidence were valid at the time the decision to purchase was made. These included:

1. low interest rates;

2. a favourable business climate and employment in the area;

3. a low vacancy rate for rental units;

4. a buoyant residential real estate market; and

5. the rental unit was to be a new home and therefore repairs and maintenance costs would be low in the early years.

Based upon these and other factors, the appellant believed that a strong case could be made for purchasing 74 Alderbury. It was her conclusion that under these circumstances there would be a reasonable expectation of profit at the time the purchase was originally made or at least within the foreseeable future. This belief, together with a buoyant real estate market, led the appellant to conclude that not only would the rental operation be profitable but that within a number of years the property would appreciate so as to produce additional funds for her family’s educational needs, if sold.

The agreement of purchase and sale for 74 Alderbury was a binding and enforceable contract and the appellant was required to complete the purchase. However in the interim between the signing and closing, many of those assumptions proved not so much to be incorrect or without foundation but altered or changed because of circumstances many of which were out of the appellant’s control.

Among these changes in circumstances were substantial increases in interest rates, a sluggish economy, a markedly depressed real estate market and increased vacancy rates for residential properties. In addition, not only were local industries such as IBM not increasing their employment but some were in fact laying off employees.

It became clear to the appellant even before closing that interest expense, which was not locked in at the time of purchase, would outstrip rents which in turn were less than forecast. In fact, the appellant advertised rent at a lower rate than anticipated even before closing.

Using forecasts made prior to signing the agreement of purchase and sale, it appeared that profit was marginally attainable in the short term and that by paying down principal as quickly as possible there would be an accompanying decrease in interest expense. The appellant’s evidence showed that from 1990 to 1992 interest expense decreased from $35,500 in 1990 to $29,000 in 1991, to $24,300 in 1992.

Although the 1993 and 1994 years were not under appeal, it was her evidence that interest expense continued to be reduced to $24,000 in 1993 and $19,200 in 1994. However in those years (1993-94) because of low rent ($1,000 per month) the operation still suffered losses. It was alleged by counsel for the respondent that the funds for principal reductions came from the income tax refunds which arose from the rental losses. There was no evidence that this was the case.

Part of the Minister’s reason for disallowing the rental expenses stems from his assumption that borrowings were larger than the appellant’s forecasts. Although the appellant and her spouse borrowed $30,000 from the Bank of Nova Scotia, I find that these funds were used not in connection with the purchase of 74 Alderbury as alleged by the Minister, but were used to reduce the mortgage on their matrimonial home since the rate charged for the loan was less than the mortgage rate on the home.

It was also pointed out that the additional $30,000 to be paid on closing failed to materialize resulting in an increase in the principal of the mortgages from the one forecasted, of approximately $200,000, to the two mortgages aggregating $230,000.

The $30,000 was not advanced but was used to defray increase costs especially interest expenses. However, it was demonstrated that even with a $230,000 mortgage profitability was still not impossible.

The issue of reasonable expectation of profit is not to be determined by 20/20 hindsight after the fact, but what must be examined are the facts as they existed at the time the investment was made. Even though events changed and profitability became less likely, that in itself is not determinative of the issue.

As Jerome A.C.J. of the Federal Court-Trial Division said in McGovern v. Minister of National Revenue, [1994] 2 C.T.C. 231, 94 D.T.C. 6527 (F.C.T.D.) at page 233 (D.T.C. 6528):

There is no question the Minister is entitled to disallow losses with respect to a business venture which have been accepted in previous taxation years. Generally, this will occur where the project, which may have initially possessed a reasonable expectation of profit, suffers consecutive losses such as would indicate it has become a losing proposition. However, where the business venture, under normal circumstances, would have realized a profit but fails to do so because of a dramatic change in conditions, a taxpayer should be granted a reasonable period of time in which to ascertain that no income is likely to be earned.

This was the principle applied by the Tax Court of Canada in Aucoin v. Minister of National Revenue, [1991] 1 C.T.C. 2191, 91 D.T.C. 313. In that case, the taxpayer purchased a condominium in Florida for the purpose of earning rental income. He rented the condominium for a one year period at a monthly rental of $750, but owing to a sharp decline in property values throughout Florida, the taxpayer was forced to reduce the monthly rent to $525. Shortly thereafter, Mr. Aucoin attempted, without success, to sell the property but finally decided to withdraw it from the market because of poor real estate market conditions. In computing his income for his 1984, 1985 and 1986 taxation years, the taxpayer sought to deduct rental losses generated from the property which the Minister disallowed on the grounds Mr. Aucoin had no reasonable expectation of profit. In allowing the appeal from the Minister’s reassessment, Garon J. made the following comments at page 2193 (D.T.C. 316):

it would be unreasonable, in my view, to conclude that the appellant ceased overnight to have a reasonable expectation of profit in connection with the rental of the subject property as soon as the slump in the real estate market surfaced. He could have reasonably believed that the drop in the rental market was temporary and there is some suggestion in the evidence to this effect. On the other hand, it would not be realistic for the appellant to expect, say in 1989 to earn income from that property after a string of five years of losses and no real improvement in the market situation. /t seems to me that there is a point between these two extremes where a prudent and reasonably informed person would have realized that no income would likely be earned for quite some time from that property. I would believe that point must have been reached two or three years after the occurrence of the drastic change in the real estate market.

[Emphasis in original.]

Here, the appellant should be allowed to attempt to improve the situation. In fact through a reduction of interest expense the losses were reduced. This was coupled with the fact that as soon as it became apparent that conditions had changed, the appellant attempted to extricate herself from this situation by listing the property for sale. Rather than be construed as a secondary intention to “flip” the property, this conduct should be considered the act of a prudent person attempting to get out from under.

The appellant and her partners had three alternatives. The first was to sell out and cut their losses. This was attempted but was not successful. The second was to attempt to rent by advertising in various places. The house was rented from February 1, 1990 to May 31, 1990 at $1,100 per month; from July 16, 1990 to January 17, 1991 at $1,200 per month; from March 27, 1991 to August 31, 1991 at $1,050 per month and from October 1, 1991 to date at $1,050. Of course, none of this rental income was sufficient to carry the mortgage. The third alternative was bankruptcy. This was not an alternative the appellant and her spouse were prepared to accept having regard to their other assets which would be in jeopardy.

What was done was not unreasonable having regard to the initial plan. In fact what was done was eminently reasonable under the circumstances.

From the outset, the appellant did what a prudent investor would do and based on her studies and findings at that time it was not unreasonable for her to conclude that profitability was in her future if not immediately, in the foreseeable future.

Whether the appellant can continue to deduct rental losses in subsequent years is not for this Court to determine. Contrary to that which was claimed by the appellant on her tax returns for the years in question, there were not two equal partners, 1.e., the appellant and her sister, but three partners, the appellant and her spouse as to 25 per cent each and the appellant’s sister as to 50 per cent. Therefore, the appellant was not entitled to deduct one-half of the losses claimed but only one quarter of them.

Accordingly, the appellant’s appeals with respect to 74 Alderbury are allowed for the 1990, 1991 and 1992 taxation years and the matter is referred back to the Minister of National Revenue for reconsideration and reassessments on the basis that the appellant is entitled to deduct one quarter of the rental losses on 74 Alderbury, with no deductions for capital cost allowance. The total losses for those years being $34,332; $27,003; and $16,732, respectively.

The appellant is entitled to no further relief.

Appeal allowed in part.