Leslie Karpati v. Her Majesty the Queen, [1996] 3 CTC 2412 (Informal Procedure)

Bowman J.T.C.C.: — These appeals are from assessments for the 1991, 1992 and 1993 for Leslie Karpati and for 1992, 1993 for Kate Karpati. They involve the denial of losses sustained by Dr. and Mrs. Karpati on a property located at 120 Promenade Circle, Suite 1202, Thornhill, Ontario.

Dr. and Mrs. Karpati at the time of trial were about 70 years of age. Dr. Karpati is a medical doctor. In 1989, Dr. Karpati was considering retiring. They had sold their house and were looking to find an investment that would provide income after retirement and in their old age. It seems clear that the decision to buy the condominium at 120 Promenade Circle was Mrs. Karpati’s. She could see that at that time prices were escalating and evidently believed that if they did not buy then they would have to pay more later. It was not suggested that the purchase was speculative. As it turned out, they bought at the peak of the market, although this could not have been foreseen.

The property, a two bedroom condominium, was bought before it was built at cost of $305,500 and was owned jointly by Dr. and Mrs. Karpati.

The respondent states in the replies to the notices of appeal that it was assumed that the purchase was financed with a mortgage of $166,500 and a bank loan of $139,000. This was not Mrs. Karpati’s evidence. It appears that they paid between $40,000 and $55,000 cash and the balance was financed.

The property was completed at the end of 1990 and was first rented either at the end of that year or the beginning of 1991 to two arm’s length tenants at $1,100 per month. When one tenant moved out Mrs. Karpati agreed not to raise the rent and this situation prevailed until 1995 when they raised the rent to $1,600 per month. In 1994, their son and his fiancee moved in.

The income and loss claimed by the appellants were as follows:

The interest expense deducted in the above calculation was $30,865, $22,078 and $18,996 for 1991, 1992 and 1993 respectively. The condominium fees were $3,527, $4,307 and $4,307 for those years.

Mrs. Karpati testified that by 1995, they had almost reached the breakeven point, as the result of lower interest rates, lower taxes and higher rentals.

The assessment was based on the assumption that the amounts were not laid out for the purpose of gaining or producing income but were personal and living expenses of Dr. and Mrs. Karpati and that there was “no reasonable expectation of profit”.

As an alternative, the Crown argued that the expenses were “unreasonable”.

I do not accept that the amounts were not laid out for the purpose of gaining or producing income. The object was to provide income for their retirement. There was no personal element in the investment at all. In the years in question the property was occupied by arm’s length tenants and the definition of “personal or living expenses” in the Income Tax Act has no application. Nor can I accept that there was no reasonable expectation of profit. It seems that the department pounced with remarkable alacrity on the first year of rental operations. Each year the losses have been declining and Mrs. Karpati stated that, notwithstanding what was said in a questionnaire completed by her, they hope to pay the mortgage down if Dr. Karpati continues to work.

I shall not repeat the principles laid down in the recent decision of the Federal Court of Appeal in Tonn v. R. (sub nom. Tonn v. Canada), [1996] 1 C.T.C. 205, 96 D.T.C. 6001 (F.C.A.), beyond noting that:

(a) There was no personal element involved here at all. The motivation was purely commercial.

(b) The Department has failed to give the appellants a reasonable period of time to make their investment a profitable one.

(c) The circumstances do not admit of any suspicion that the business loss was made for a personal or non-business purpose.

(d) It is inappropriate, with the benefit of hindsight, to second guess the taxpayers’ business judgment. (Gabco Ltd. v. Minister of National Revenue, 68 D.T.C. 5210)

The appellants’ here are not sophisticated investors and with the benefit of hindsight their investment may have turned out to be imprudent. Nonetheless it was made in good faith and with a purely commercial intent.

So far as the respondent’s alternative argument is concerned, that the expenses are unreasonable, I would be inclined to agree that in some circumstances, where the purchase is almost entirely financed with borrowing it might, in some circumstances, be unreasonable to permit a deduction of all of the interest. This is, however, a factual determination to be made on the basis of all of the evidence, including the taxpayers’ other investment and commitments of capital. For example, it might be reasonable for a taxpayer to purchase property on a highly leveraged basis rather than liquidate other investments.

Here, I have no yardstick by which to measure the reasonableness of the financing arrangements. Since the reasonableness position was not the basis of the assessment, the onus was on the Crown to establish what portion of the expenses was unreasonable. This has not been done. Certainly I cannot accept that all expenses in excess of the gross revenues are unreasonable. That proposition is wrong on its face. It would mean that no losses could ever be deducted. The expenses in question here — interest, condominium fees and municipal taxes — were all incurred at arm’s length and were beyond the appellants’ control.

In the circumstances, the appeals are allowed and the assessments for 1991, 1992 and 1993 for Leslie Karpati and for 1992 and 1993 for Kate Karpati are referred back to the Minister of National Revenue for reconsideration and reassessment to permit each appellant to deduct a loss in computing their respective incomes of 50 per cent of the losses of $22,881, $15,779 and $13,008. I note that for 1991 Dr. Karpati claimed the entire loss of $22,881 and Mrs. Karpati claimed nothing. Mrs. Karpati did not appeal her 1991 assessment. In the absence of any evidence that the attribution rules apply, Dr. Karpati is entitled only to 50 per cent of the 1991 loss. Since there is no appeal by Mrs. Karpati for 1991, I cannot order that her assessment for that year be adjusted to allow her the other one-half of the loss.

Appeal allowed.