John Pegg v. Minister of National Revenue, [1987] 1 CTC 2404, 87 DTC 325

Taylor, T.C.J.:—This is an appeal against income tax assessments, for the years 1980, 1981 and 1982, heard in London, Ontario, on March 2, 1987, in which the Minister of National Revenue disallowed the rental losses claimed. The Minister's reply to notice of appeal sets out the dispute:

Statement of Facts

— In or about July 1979, the Appellant and his spouse purchased lots 33 and 34 of Stephen Township, consisting of approximately 124 acres of farm land for a total consideration of $107,500.00 (lots 33 and 34 are hereinafter referred to as the “Subject Property”).

— In his 1980, 1981 and 1982 Income Tax Returns, the Appellant reported gross rents and expenses giving rise to losses from the rental of the Subject Property. Particulars of the income, expenses and losses arising from the Subject Property are as follows:

	1980	1987	1982 1982
Gross Rent	$ 2,500.00 $ 3,375.00 $ 3,750.00
Property Taxes	204.88	431.78	734.29
Interest	16,393.02	12,439.25	10,139.05
Drainage		—	583.11
	—
Insurance	108.00	120.00	120.00
Landscaping	—	192.50	—
Losses	(14,205.90) ( 9,808.53) ( 7,826.45)

— In 1980, the Appellant and his wife divided the losses arising from the rental of the Subject Property with the Appellant and his spouse each claiming $7,102.95. For the 1981 taxation year, the Appellant claimed a loss of $4,904.27 whereas the Appellant's spouse claimed a loss of $4,904.26. For the 1982 taxation year, the Appellant claimed a loss of $3,913.23 whereas the Appellant’s spouse claimed a loss of $3,913.22.

— that the outlays or expenses claimed by the Appellant with respect to the Subject Property were not made or incurred by the Appellant for the purpose of gaining or producing income from a business or property;

— that there was no reasonable expectation of profit arising from the rental of the Subject Property;

— that the expenses claimed by the Appellant respect to the Subject Property were personal or living expenses of the Appellant.

— The Respondent relied, inter alia, upon sections 18, 169 and 248 of the Income Tax Act, R.S.C. 1952, Chapter 148 as amended.

According to the appellant’s testimony, when acquired the property had on it an old house, which he intended to renovate and rent — his estimate of that cost was $10,000 to $12,000. He did rent out a portion of the acreage to a local farmer, who also installed some tile drainage as part of the agreement. Mr. Pegg could not get a building permit for the reconstruction of the old house, so he tore it down, and still has stored certain portions from it, hoping some day to rebuild the house — for rental purposes. He did not have sufficient funds available to do this up to this point in time. When built and ready he hoped that the new house would bring in $500-$550 per month. Some work had to be done by the Department of Lands and Forest on clearing out and improving some wood lot lands on the property, from which he hoped some day to gain revenue. Essentially, his expectations, were and remained, that some day he would get revenue from three sources — rent of the farm, rent of the house (when built), sale of wood (when ready). Mr. Pegg filed with the Court a schedule (Exhibit A-1) showing the approximate results since 1982, and some projections beyond as follows:

JOHN PEGG

Stephen Township Farm

Rental Income

	1983	1984 1985		1986	1987	1988	1989
Rent	$ 5,000	5,000	5,000	5,750	6,000	6,000	6,000
Expenses
Interest	7,835	10,490	8,323	5,621	1,823	1,823	1,823
Insurance	325	120	120	120	120	120	120
	8,160	10,610	8,443	5,741	1,943	1,943	1,943
(Loss)
Income	$(3,160)	(5,610)	(3,443)	9	4,057	4,057	4,057

Counsel for the Minister noted that without substantial corroboration, the projections for future years would have little value to the taxpayer in this appeal.

The agent for the appellant noted in argument that the appellant had reduced the mortgage interest obligation over the years, and that according to Exhibit A-1 he was now showing the profit that he expected. The taxpayer was entitled to deduct the "start-up" costs he had incurred in the early years according to the agent.

Counsel for the Minister stressed that even looking at the main item of expense — the mortgage interest — the appellant would not probably have had a "reasonable expectation of profit” from the purchase of the property.

Analysis

Dealing with the argument regarding "start-up" costs, the significant references to "start-up" costs which may be found in the jurisprudence largely deal with "farm-loss" cases, as I understand it, and I would think that to generalize from that basis would not be a helpful exercise. There may be exceptions — but "start-up" costs are often those associated directly or indirectly with bringing to production capability an income-earning asset — nominally a capital cost as I see it. The agent for the appellant provided an analogy for start-up "costs", which dealt with “repairs and maintenance” to a rental property — but I would point out that the line of cases dealing with that aspect of the matter leaves little room for optimism on the part of a taxpayer. Reference could be made to Audrey B. Wager v. M.N.R., [1985] 1 C.T.C. 2208; 85 D.T.C. 222, Stephen Coleman v. M.N.R., [1984] C.T.C. 2725; 84 D.T.C. 1637, and Rudolph L. Dallos v. M.N.R., [1985] 2 C.T.C. 2021; 85 D.T.C. 417. While it might be very convenient for a taxpayer to consider heavy initial expenditures as "start-up" costs, the circumstances under which that appellation can aid a taxpayer in supporting a current deduction are limited. When dealing with "major repairs and maintenance" on a building (see jurisprudence above) it is sometimes possible to perceive the payments as on account of capital — in the sense that a capital asset is being improved or enhanced. That situation, for a taxpayer, may result only in a longer period of recovery of his investment (through C.C.A. etc.) rather than more immediate write-off. That arises out of the prohibition found in paragraph 18(1)(b) of the Act, which paragraph only comes into play in my view after it has been determined that the transaction at issue meets the fundamental requirement of paragraph 18(1 )(a) — "for the purpose of gaining or producing income”. In the instant appeal the choice for the Minister is not between paragraph 18(1)(a) and 18(1)(b), as it sometimes may be with regard to "major repairs and maintenance” but rather the single proposition that the expenditures at issue (of which mortgage interest is the major item by far) do not meet the "for the purpose of gaining or producing income” criterion. There is no question that "mortgage interest” as such may be deductible — it is covered under subparagraph 20(1)(c)(ii), in case there is any question as to its deductibility arising out of section 18. However that subparagraph (20(1)(c)(ii)) contains the same qualification ". . . for the purpose of gaining or producing income”, as one finds in paragraph 18(1)(a).

It was the contention of Mr. Pegg, that the property would start to show a profit when he had reduced the mortgage interest considerably (by paying off the loans) and his Exhibit A-1 (supra) was designed to show that had been accomplished. While Mr. Pegg would also like the Court to take into account the prospect of rental from a house (when it is built), that is too speculative in my view, and at the minimum would entail substantial additional investment, and on-going costs the extent of which were not described to the Court. It seems to me that from the outset, in 1979, Mr. Pegg was fully aware of at least two things — he might rent the farm for $4,000 to $5,000 (it turned out to be $2,500 the first year); and he would be faced with very substantial mortgage interest payments. Putting that in an oversimplified fashion even at the highest, the pro-form expectations, of Mr. Pegg, for the property must have been:

He was therefore fully aware that he would be required to add — at least — another $24,000 to his investment before he could start to recover anything. The agent for the appellant counters that Mr. Pegg could see that some year down the line (Exhibit A-1) the operation would come into the black, and that in the meantime — with just that as a prospect — Mr. Pegg is entitled to the deductions he claims.

I do not reject the proposition that a certain period of time may well be required before any operation can become profitable. It would appear that Mr. Pegg would have been satisfied with only a very modest return on his investment (even by his projection about $4,000 in 1988 on a cost of considerably more than $100,000). But the $24,000 noted above had to come from further investment by Mr. Pegg — it could not conceivably come from anticipated revenue — and that seems to be a clear example of providing additional capital. The minimum capital base evident to Mr. Pegg when he entered into the proposition was $131,500 ($107,500 + $24,000), before he could even hope for a return. That is certainly considerably removed from any "reasonable expectation of profit”.

The Minister has indicated that the expenses at issue were "personal or living expenses”, and that may be an adequate description. The Minister has not been prepared to identify them, for assessment purposes, as "capital expenditures”. This Court need only determine if the disputed amounts are "current” expenses, and they are not. "Neither personal” nor "capital" costs become "current" costs for income tax deduction purposes, merely by glossing them over with a "rental" veneer, or by attaching to them the description of "start-up costs".

The recent "farm loss” cases* [1] may leave some area of uncertainty with regard to the determination of the question of "restricted farming losses” and “full farming losses”, but they do seem quite clear with regard to the underlying question of "reasonable expectation of profit”. I find no comfort for this taxpayer in any of that jurisprudence.

The appeal is dismissed.

Appeal dismissed.