Lombardi v. R., [1998] 1 CTC 2898

Archambault T.C.J.:

Mr. Lombardi is appealing income tax assessments issued by the Minister of National Revenue (Minister) in respect of the 1992, 1993 and 1994 taxation years (relevant period). The Minister denied the deduction of rental losses in the amount of $6,771 for 1992, $5,084 for 1993 and $4,441 for 1994. The parties have agreed that the only issue for this Court is whether Mr. Lombardi had a reasonable expectation of profit in renting part of a triplex that he owned.

Facts

Mr. Lombardi bought his triplex located in St-Leonard, Quebec, in April 1991 for the sum of $230,000 of which he paid $55,000 out of his own pocket while financing the balance with a mortgage loan of $175,000, which amount represented 76% of the cost of the triplex.

The mortgage loan, taken for a term of five years, bore interest at the rate of 11%, which worked out to a monthly payment of $1,600. Under the terms of this loan, Mr. Lombardi was entitled to pay it down each year by 10%. In fact, Mr. Lombardi paid down an amount of $10,000 during the course of the first term. He agreed to being locked into a five-year term because he wanted to freeze interest costs on the loan for this period. He was concerned that the rate of interest might go back to the high rate of 18% that had prevailed in prior years.

Mr. Lombardi intended to use one of the five-and-one-half-room apartments for his personal use; the other two units were to be leased. The vendor was allowed to occupy Mr. Lombardi’s intended apartment for two months after the sale and he paid $1,000 per month to Mr. Lombardi in May and June of 1991.

One of the other two units was a basement apartment consisting of three and a half rooms which were leased to his mother-in-law for a monthly rent of $310. This rent represented an increase of $10 per month over the rent collected by the previous owner of the triplex. The previous tenant’s lease expired on June 30, 1992. His mother-in-law spent approximately $3,000 to upgrade this apartment.

The second unit was an upstairs five-and-a-half-room apartment which was rented to an unrelated tenant for approximately $575 per month. When Mr. Lombardi bought the triplex, this apartment was leased for $570 per month.

Mr. Lombardi stated in Court — and I believe him — that his intent was to earn enough rent not only to pay the expenses related to the two rental units but also to pay the expenses relating to his own apartment. In other words, he intended to make a profit.

Mr. Lombardi incurred losses from 1991 to 1995. Exhibits R-l to R-3 provide the details of the losses. In allocating the total expenses between the rental and the personal portion of the triplex, Mr. Lombardi attributed only 40% to the personal portion in 1992 and 1994 and 46% in 1993.

In 1996 he made a profit of $2,848. In his estimation, he will make a $4,304 profit in 1997. These profits have been computed on the basis of a 60% allocation of expenses to the personal portion. Another important factor which explains the showing of a profit both in 1996 and 1997 is the fact that Mr. Lombardi renewed his mortgage in 1996 not only at a lower rate of interest of 774%, but on a reduced outstanding loan of approximately $140,000.

Analysis

The Respondent argues that Mr. Lombardi did not have any reasonable expectation of profit because the rent did not cover the fixed expenses of property taxes, interest and insurance costs. In Mastri v. R., file number A- 650-96, 1997 CanRepNat 852 [Reported (1997), 216 N.R. 74 (Fed. C.A.)] (TaxPartner CD-ROM), the Federal Court of Appeal recently reaffirmed the principle stated by the Supreme Court of Canada in the famous case of Moldowan v. R. (1977), [1978] 1 S.C.R. 480 (S.C.C.), namely that a taxpayer cannot deduct losses from a business or property unless there is a source of income. Furthermore, no such source of income exists unless there is a reasonable expectation of profit. This is the case whether or not the appeal involves a personal element or an inappropriate deduction of tax. Mastri also confirms the approach taken in Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.), which is that it is not for the Court to second guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated.

Here, I am satisfied that a reasonable expectation of profit existed with respect to the rental portion of the triplex. Mr. Lombardi bought the triplex both for his personal use and for rental purposes. In this case, I find that two of the three apartments were used for rental purposes. The rent charged to his mother-in-law was higher than the rent collected by the previous owner from an unrelated tenant. She also spent about $3,000 to upgrade her apartment.

This was Mr. Lombardi’s first experience with this kind of endeavour. He expected to lose money for the first couple of years and to be able to increase his rent to make the venture profitable thereafter. He also expected to reduce his monthly mortgage payments by paying down the mortgage loan and he actually did so by $10,000 over the course of the first term. He took a five-year term, which proved, with hindsight, to be a bad decision but nobody can look into a crystal ball and foresee the future. In fact, Mr. Lombardi was able to renew the mortgage at a lower rate of interest, which helped him make a profit in 1996. He expects an even higher profit in 1997.

As Judge Bowman stated in Bélec c. R. (1994), 95 D.T.C. 121 (T.C.C.), 123:

It would be equally unacceptable to permit the Minister to disallow the deduction for losses at the beginning of a business’s activities on the assumption that there was no reasonable expectation of profit, and then, after the business succeeded, to demand part of the profits as taxes by saying to the taxpayer. The fact that you lost money when you began the business proves that you did not have a reasonable expectation of profit, but as soon as you earn some money, it proves that you have now such an expectation.

It is interesting to note that Mr. Lombardi is allocating 60% of his total expenses to his personal portion starting in 1996. This also has an impact on determining whether the leasing of the two units can generate a profit, as we will see shortly. This 60% appears to be a reasonable allocation given that the percentage represented by Mr. Lombardi’s personal expenses may well exceed the percentage of floor area actually occupied by him for personal use. I do not think that the actual floor area should be the only factor in determining what constitutes a reasonable allocation of expenses between the personal and rental potion of a property. Other factors would include whether a unit is situated on the ground floor or in the basement, what rights tenants have to use the driveway and the backyard, and for which unit expenses are actually incurred.

As mentioned above, Mr. Lombardi used only a 40% and 46% allocation for his personal portion in computing his rental losses during the relevant period. If I were to recompute his rental income or losses for the relevant period while using, for computing his gross income, the full amount of rent stipulated in his leases, and for computing his expenses, only 40% of the actual expenses incurred, instead of a cumulative loss, the rental would have generated an aggregate net income of $617. There would have been an income of $180 in 1992, a loss of $169 in 1993 and an income of $606 in 1994. It is therefore apparent, on taking into account all the circumstances of this case, that Mr. Lombardi had a reasonable expectation of profit when he embarked upon the endeavour in question.

Before concluding, I would like to stress the following message issued by the Federal Court of Appeal in Tonn, supra, at page 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. They need not resort to the more heavy- handed Moldowan test. In fact, in many cases, resorting to section 67 may well be more appropriate. This point has been made more than a few times by Bowman, T.C.C.J. In Cipollone v. Q., for example, the taxpayer attempted to deduct a variety of large expenditures as part of her “humour therapy” business. Despite the unusual nature of the business, Bowman, T.C.C.J. found the business to be bona fide and thus not a candidate for the application of Moldowan. He added:

The reason her losses were as great as they were was not because the business had no reasonable expectation of profit or because she was not expending money for the purpose of gaining or producing income from a business. I find as a fact that she was spending money in order to earn a profit and that expectation of earning a profit was reasonable, if she had chosen to claim reasonable expenses. The problem lies not in the absence of a reasonable expectation of profit — businesses of this sort can be quite lucrative — but rather in the attempt to deduct unreasonable expenses.

Before deciding to deny all the losses that a taxpayer is claiming, the Minister should determine first whether the expenses are reasonable and then whether some of them are of a personal or of a capital nature. If the Minister was to follow this approach, not only would it be fairer for Cana- dian taxpayers but it might result in less litigation before this Court because taxpayers would be less inclined to contest their assessment if only a portion of their expenses was disallowed.

Here, had the Minister determined that the personal use by Mr. Lombardi of the triplex represented a proportion of 60%, most of the losses would have disappeared and income might even have been generated. Given that the only issue before this Court was whether Mr. Lombardi had a reasonable expectation of profit, and having concluded that such an expectation existed, it would be inappropriate to disallow a portion of the expenses.

For these reasons, the appeals will be allowed and the assessments for the 1992, 1993 and 1994 taxation years are to be referred back to the Minister for reconsideration and reassessment on the basis that Mr. Lombardi was entitled to claim his rental losses. Mr. Lombardi is also entitled to his costs.

Appeal allowed.