Mohammad v. R., [1997] 1 CTC 2522 (Informal Procedure)

Mogan J.T.C.C.: — This is an appeal in respect of the taxation years, 1989, 1990 and 1991, in which the Appellant has elected the informal procedure. The only issue before the Court is whether certain losses can be deducted by the Appellant when computing his income for the years under appeal. Those losses relate to his participation in the ownership of a residential property described as 2779 Kingsway Drive in Oakville, Ontario.

The relevant facts can be stated briefly. In 1987, the Appellant and a man named Peter Robbins decided to purchase this property in Oakville and use it as a rental property. The Appellant and Peter Robbins are not related to each other and dealt with each other at arm’s length. It was an intended business venture on their part. They did not need the property as a personal residence but, according to the evidence of the Appellant (and I believe him), they hoped to rent it for a few years and then sell it for a capital gain. That was not an unreasonable intention back in 1987 and 1988 because the real estate market in southern Ontario was in a kind of meteoric rise in the last three or four years of the 1980’s, from 1985 until 1989, when it peaked and then fell dramatically throughout the calendar year 1989.

In November 1987 the Appellant and Mr. Robbins purchased the property at 2779 Kingsway Drive in Oakville at a cost of $176,596. For convenience, I shall simply refer to it as “the property”. It was a four- bedroom residential home. At the time of the purchase, there was a first mortgage on it in the amount of $131,775. That left a gap of approximately $45,000 between the first mortgage and the purchase price. There were other costs, however, principally land transfer tax and legal fees, which brought the overall cost of the property up to something in the neighbourhood of $181,000. That left the Appellant and Peter Robbins with about $50,000 to make up between the actual cost of the house plus legal fees and land transfer tax and the first mortgage of $131,000. This $50,000 was made up by each party putting up $25,000 in cash to close the transaction. In order to raise his $25,000, the Appellant obtained a personal loan from the bank at whatever the prevailing rates were but he referred, in his evidence, to a down payment loan at 11.25% per annum.

As I have stated, it was their intention to sell the property after renting it for a number of years in the expectation that, with the real estate market holding the way it was, the property would go up in value. The fact is that they were unable to rent the property as soon as they took it over because it was in a developing neighbourhood; the streets may have been paved but there was a good deal of mud from the ongoing construction whenever it rained. They had difficulty in finding a tenant. Peter Robbins decided that he would rent it and so he moved into the property and lived there from 1987 to July of 1990 paying $1,500 a month rent.

It must be remembered that, as a co-owner, Peter Robbins was paying the rent in part to himself. Although he paid $1,500 a month rent, only half of that came to the Appellant. The Appellant had to prepare a profit and loss statement in which he would show that rent as his only revenue and deduct his half of the carrying costs. That is to say, his half of the municipal taxes, his half of whatever utilities may have been relevant which were not absorbed by Peter Robbins as the tenant, and his half of the interest portion of the mortgage payments. When Peter Robbins moved in, they negotiated a rent of $1,500 per month. In 1989, that rent was increased to $1,550 per month.

In July 1990, Peter Robbins moved out of the premises and the Appellant and Mr. Robbins leased the property to a Mr. and Mrs. Slipp at a rent of $1,250 a month. That seems to have established the fair market value of the rent because there is no evidence that the parties were related to Mr. and Mrs. Slipp; and the $1,250 a month is an indication of what the market would bear for this kind of house in July 1990.

The Appellant and Robbins attempted to sell the house in 1990/1991 but could not sell it without suffering a loss because the value of real estate had gone down in Metropolitan Toronto and the surrounding areas as far as Oakville, Hamilton and Oshawa. They did not want to sell it and suffer a loss in contrast with their purchase price of $176,000. In the summer of 1991, Peter Robbins got married and he and his wife decided that they would move into the house. Mr. and Mrs. Slipp moved out and in August of 1991, Peter Robbins and his wife moved into the house paying rent at the rate of $1,300 a month. Again, I would say that although this was a non-arm’s length relationship between landlord and tenant, that seems to have been the rental value of the house because it is in the range of what Mr. and Mrs. Slipp had been paying. Robbins and his wife continued to reside in the house and were living in it right up to the time of this appeal in 1996.

The Appellant has never lived in the house. He lives elsewhere. He never intended to use it as a personal residence and for him, it was only an investment opportunity, albeit one that had turned somewhat sour because of what happened in the real estate market in southern Ontario in 1989 and 1990. At the end of 1994, the Appellant negotiated with Peter Robbins and his wife to increase the rent from $1,300 a month to $1,350 a month and apparently, at the time of hearing, that was still the prevailing rent. Now I come to the losses. The Respondent introduced in evidence copies of the Appellant’s income tax returns for the years 1989, 1990, 1992 and 1993. The return for 1991 was not put in evidence but it was acknowledged by the Appellant the amount of the loss he suffered in that year. These are the losses reported in the tax returns of the Appellant for all of the years under appeal and the three following years (1992, 1993 and 1994).

1989: $7,245 loss

1990: 9,629 loss

1991:8,181 loss

1992: 4,484 loss

1993: 1,218 loss

1994: 760 profit

It can be seen from those amounts that there were three significant losses in the range of $7,000, $9,000 and $8,000 for the three years under appeal but in the three succeeding years, the losses dropped significantly. For 1992, the loss was about one-half of the average for the three years under appeal and, in 1993, it was down to $1,200. For 1994, there was a modest profit.

The Respondent disallowed the deduction of these losses on the basis that there was no reasonable expectation of profit and also that the expenses were not reasonable in the circumstances, relying on section 67 of the Income Tax Act. The question of whether there was a reasonable expectation of profit in a transaction like this has been the subject of significant litigation in recent years but, in particular, a recent decision of the Federal Court of Appeal, Tonn v. R., [1996] 1 C.T.C. 205, 96 D.T.C. 6001 is what I would call the last word on what the Courts have said concerning the issue of reasonable expectation of profit.

I do not propose to review all of the jurisprudence in this matter because it is well reviewed by the Federal Court of Appeal but, in a nutshell, the phrase “reasonable expectation of profit” appears in the definition of personal and living expenses as that phrase is used in paragraph 18( l)(h) of the Income Tax Act. It was also given what might be called a common-law status in the 1977 decision of the Supreme Court of Canada in Moldowan. What the Federal Court of Appeal has made clear is the difference between the objective test with respect to reasonable expectation of profit: whether it has to be measured by objective standards, and the subjective test being the intent or purpose of the taxpayer when he incurs expenses connected with what he believes is a commercial operation. There is a brief passage in Tonn which I would refer to, at page 225 (D.T.C. 6013) where Linden J.A. delivering the decision for the Court states (starting in mid-sentence):

I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other- than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

What the Court was referring to was the kind of case in which a person has purchased a principal residence for his or her family and is attempting to rent out a few rooms, simply to help defray the cost of carrying the property, but then purports to claim that the renting of those rooms is a business enterprise. By allocating a disproportionate share of the house expenses to the rented rooms, the owner shows that the rental operation is suffering a loss and he then tries to apply that loss against other source income, thereby reducing his tax otherwise payable. That is the kind of situation in which there is a personal element.

Similarly, a person who buys a farm near the city where he works and purports to operate the farm as a commercial farming enterprise when, in reality, he is just trying to give to himself and his family the enjoyment of living in the country, there is a personal element. That is the kind of personal element case where, quite rightly, the Moldowan test can be applied, or to use the words of Linden J.A. “... where the expectation of profit was so unreasonable as to raise a suspicion ”. None of those circumstances arise here with respect to the Appellant because he never used the property as a personal residence. He never used it as a dwelling nor did he use it to house any members of his more immediate family or more remote family. It was purchased by him and Mr. Robbins, arm’s length parties, as a commercial enterprise. It was used by Mr. Robbins in 1987 only because they could not find an arm’s length tenant. The personal element does not exist in this appeal. Therefore, having regard to the decision of the Federal Court of Appeal in Tonn, I am more reluctant to apply the more strict test of Moldowan in terms of whether there was a reasonable expectation of profit.

The Appellant produced as an exhibit and attached to his Notice of Appeal a projection of rents which he prepared in 1987. In retrospect, with the benefit of hindsight, knowing what happened to the real estate market in Metropolitan Toronto, those projections appear to be unreasonable and yet, at the time, given the temper of the times and the mood of the market, I am not prepared to say that they were unreasonable in terms of the objective of Mr. Robbins and the Appellant. Therefore, I am inclined to apply the Tonn decision in the Appellant’s favour, with some qualifications, with regard to the losses he has claimed; and I will now explain the qualifications I have with regard to the Appellant’s case.

There is a further relevant passage from the Tonn decision at page 6008 where Linden J.A. has recited a number of cases and then he makes the following statement:

Summarizing the above analysis, the Moldowan test, though similarly worded, does not derive from any of the deductibility provisions in sections 9, 18, and 20. The test is much like the business intention tests of subsection 9(1) and paragraph 18(l)(a), but it contemplates stricter application because of its objective nature. To be sure, the objective aspect of the Moldowan test is the most significant feature distinguishing it from the general deductibility tests in the Act. This feature of the test has been criticized because objective reasonability may be used unfairly to police the business decisions of taxpayers from a position of hindsight.

I think that was the condition on which the Court of Appeal allowed the taxpayer’s appeal in Tonn because there was no personal element; and the Court felt that, with the benefit of hindsight, the tax department was saying that there was no reasonable expectation of profit. That is what I am applying here.

Having said that, however, it is necessary to consider what happens in cases like this. The Appellant has deducted in computing his income a loss from a rental operation. As everyone knows from elementary accounting, a loss is the negative result which follows when expenses exceed revenue. It is the loss which is deducted and the loss which is challenged by the Minister. I am finding in the Appellant’s favour here that, in his specific circumstances, there was a reasonable expectation of profit. His loss should not be disallowed as a deduction.

Notwithstanding that finding, the Minister is entitled to challenge certain expenses. Again referring to the Tonn decision, Linden J.A. stated, at page 219 (D.T.C. 6009):

It seems to me that for most cases where the department desires to challenge the reasonableness of a taxpayer’s transactions, they need simply refer to section 67. This section provides that an expense may be deducted only to the extent that it is reasonable in the circumstances.

This leads me to the question of whether all of the Appellant’s expenses are reasonable in the circumstances. The Appellant has financed 100% of his total cost. The cost of the property alone, the purchase price, was about $176,000. Other expenses like legal fees and land transfer tax brought the total cost up to about $181,000. The Appellant and Robbins assumed the first mortgage on the property of $131,000 and then they put up $50,000 in cash; but the Appellant borrowed his $25,000.

In my opinion, the deductibility of the interest on the borrowed down payment amount was not a reasonable expense. That interest ought to be disallowed under section 67 of the Income Tax Act. It is not reasonable for any individual (or partnership in this case) to purchase real estate; borrow 100% of the cost; and then expect to rent it out and earn a profit after deducting the interest on 100% of the cost.

The Appellant states that his objective was to make a capital gain but, to be a capitalist, one must have some capital. The Appellant did not have any of his own capital in this transaction. It was all borrowed money. As a rental operation, the venture was under-capitalized. The 100% financing of the property was not reasonable. I gain some comfort in the position I take from the decision of this Court in Cheesemond v. R., (sub nom. Cheesemond v. Canada) [1995] 2 C.T.C. 2567 (headnote only) (T.C.C.), a decision of Bowman J. Cheesemond is referred to by Linden J.A. in the Tonn decision, at page 222 (D.T.C. 6011) as follows:

In a contrasting case, the taxpayer attempted to deduct rental losses on a property. While recognizing that it is inappropriate for the Minister or the Court to substitute its business judgment for that of taxpayer, Bowman, T.C.C.J. found that the operation did not meet the Moldowan criteria:

Linden J. A. then quotes from the decision of Bowman J. in Cheesemond as follows:

Nonetheless, there must be sufficient of the indicia of commerciality to justify the conclusion that there is a real commercial enterprise being conducted. I do not find that the arrangements made by the Appellant contain those indicia. The 100% financing, the payment of a 25% commission to Port Charlotte Homebuilders and the substantial expenses and consequent loss in comparison to the gross revenues and the overall cost of the property are among the factors that I find inconsistent with a genuine commercial operation.

Bowman J. dismissed the appeal in Cheesemond and one of the factors which influenced him was the 100% financing. Therefore, while I am allowing the appeal to permit the deduction of part of the loss suffered in this rental operation, I find that the interest paid by the Appellant with respect to the $25,000 he borrowed as his down payment contribution is an expense that is not reasonable in the circumstances under section 67 of the Income Tax Act. I accept the invitation of the Federal Court of Appeal at page 6009 of Tonn to apply section 67 in these circumstances. That would apply to the three years under appeal. I know that those are the only years under appeal and I cannot affect the future, but I will take cognizance of the fact that subsequent years came out in evidence..

I was impressed by what I would call the business diligence of the Appellant. He always sought opportunities to reduce his expenses. He shopped for the lowest interest rates on the mortgage. The property was not vacant for a single day. It was rented to his partner, Mr. Robbins, or to strangers. They had searched the market carefully and purchased this property because it was close to the Ford plant in Oakville and major highways like the Queen Elizabeth ay and Highway 403. The Appellant and Mr. Robbins paid down $10,000 on the mortgage to reduce that interest charge and he also took steps to pay down his personal loan of $25,000. He said that it is now (May 1996) down to $5,000 and that he had been paying it down in years subsequent to the years under appeal.

The Appellant did something else which I take into account here because it has such a bearing on what happened in subsequent years. He learned that the interest rate on his personal loan was significantly higher than the interest on the mortgage, probably because the mortgage was so well secured by the property and his personal loan may not have been secured. Therefore, he and Mr. Robbins sometime, I believe it was in 1991, renegotiated the first mortgage and increased it to the range of $195,000 so as to permit them to repay their “down payment loans”. As I have indicated, I cannot determine the future and how subsequent years may be affected, but I would make this observation in passing. To the extent that the principal amount of the first mortgage was increased for the purpose of permitting the additional capital to be applied against the down payment loans or to make funds available to the Appellant and Mr. Robbins, I should think that the interest on the portion of the principal amount of the renegotiated first mortgage which exceeded $131,000 is not deductible in computing income.

The appeal is allowed in part and referred back to the Minister of National Revenue to reverse his decision and to allow the losses claimed by the Appellant in the years under appeal, but to reduce those losses only to the extent that the Appellant may have included in his expenses the interest that he paid on the $25,000 he borrowed to make a contribution to the down payment. That is the only expense which I would disallow among the many expenses incidental to the Appellant’s ownership of one-half of the property. If the Appellant and Mr. Robbins renegotiated the first mortgage in 1991, the interest on the portion of the principal amount of the renegotiated first mortgage which exceeded $131,000 is not deductible in computing 1991 income. For these reasons, the appeal is allowed.

Appeal allowed.