Nagasaka v. R., [1998] 1 CTC 3047

Bowie T.C.J.:

In January 1990, the Appellant and her four partners purchased a rooming house in Toronto for the express purpose of continuing to operate it as a rooming house, and thereby generate profit. For reasons which I will come to shortly, there were no profits, only losses. In each of the years from 1990 to 1994 the Appellant, in filing her income tax return, has deducted her proportional share of those losses from her employment income to arrive at her income for the year, pursuant to section 3 of the Income Tax Act, the relevant part of which reads as follows:

The income of a taxpayer for a taxation year for the purposes of this Part is the taxpayer’s income for the year determined by the following rules:

(a) determine the total of all amounts each of which is the taxpayer’s income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, the taxpayer’s income for the year from each office, employment, business and property,

(c) determine the amount, if any, by which the total determined under paragraph (a) plus the amount determined under paragraph (b) exceeds the total of the deductions permitted by subdivision e in computing the taxpayer’s income for the year (except to the extent that those deductions, if any, have been taken into account in determining the total referred to in paragraph (a)), and

(d) determine the amount, if any, by which the amount determined under paragraph (c) exceeds the total of all amounts each of which is the taxpayer’s loss for the year from an office, employment, business or property or the taxpayer’s allowable business investment loss for the year,

and for the purposes of this Part,

(e) where an amount is determined under paragraph (d) for the year in respect of the taxpayer, the taxpayer’s income for the year is the amount so determined, and

(f) in any other case, the taxpayer shall be deemed to have income for the year in an amount equal to zero.

The Minister of National Revenue has reassessed the Appellant for the taxation years 1992, 1993 and 1994 to disallow those losses, and it is from these reassessments that she now appeals.

The Appellant and her partners entered into this venture in early 1990. It appears that one of them, not the Appellant, had had some previous experience in operating rental properties, and the others were content to take his advice that this property was one from which profit could be made. The property is a semi-detached residence at 323 Jones Avenue, in an old and somewhat run-down part of the city. It was listed for sale for $225,000, and the listing indicated that it would produce an income of approximately $30,000 per year. When she was invited to join the partnership the Appellant expected that the property would produce profit from the start, and that after about two years she and her partners would be in a position to buy another property. I am sure that she saw it as the beginning of what would become a very profitable series of investments for her and the other members of the group. They were able to buy the property for $200,000, which they financed with a first mortgage for $150,000 at 11.375% per annum, a second mortgage of $30,000 at 17.25% per annum, and a third mortgage of $10,000 at 18% per annum. The Appellant put up $2,500 towards the purchase price; presumably her partners each put up a like amount, and the transaction closed on January 31, 1990.

It was not long before the Appellant and her partners found that their investment was not as sound as they had thought it to be. The first problem to emerge took the form of a letter from the City of Toronto, Department of Buildings and Inspections, advising them of certain by-law requirements which had to be remedied. The most serious of these was that they were advised that the basement of the building could not be rented due to a ceiling height requirement which it did not meet. They also were required to do some minor repairs, and to obtain a rooming-house license. Their next problem was that it became increasingly difficult to collect the rents from the tenants. Many of the tenants were welfare recipients, transients or chronic drug users. Squatters would enter the property and remain there without paying rent. The Appellant testified that she was told by the police that the house was known by them to be a crack house. It was difficult to collect rents, and almost impossible, under the provisions of the Landlord and Tenant Act, to remove people who did not pay their rent. There was considerable crime and damage to the property which the partners had not anticipated.

Losses were sustained in relation to the property in 1990 and 1991. The Appellant testified in cross-examination that the problems with the property started within a few months of the partners taking possession, and that by October 1992 she had reached the conclusion that the only solution to their problem lay in disposing of the property. Some of her partners did not agree, and a stalemate apparently ensued, with the Appellant and one other partner advocating sale of the property, and two of the partners opposing it. This situation continued through 1993 and into 1994, by which time the partners were having difficulty meeting the various mortgage payments as they fell due. By the spring of 1994 the real estate market had declined significantly, and the property was appraised by a real estate agent at $110,000 to $120,000. An attempt was made to sell it in May 1994, and at the same time to reach a compromise with the first mortgagee as to the payment of the outstanding principal. This was not successful, and the mortgagee ultimately sold the house under the power of sale in the mortgage for $127,000.

From the start the project generated only losses. It is not clear from the evidence what the loss was in 1990. The Minister has assumed that the Appellant reported her share of the loss for 1990 as $15,144. [1] The Appellant did not accept that as being correct, although she could not testify as to what the correct number is. It is obvious that one fifth of the total loss could not have been $15,144; I think it is fair to infer that it was of the same magnitude in 1990 as in the later years, and that $15,144 was the total loss in 1990. In 1991 the loss was apparently about $17,425. In 1992 it was $16,200; in 1993 it was $19,440; in 1994 the loss up to the date of the sale was $16,545. One fifth of these losses are the Appellant’s share, and were set off by her against her other income in computing her income under section 3 of the Act for the years in question.

In the three years that are under appeal the gross rental revenues were $11,700, $7,400 and $4,500. While there may be no single cause of the losses, it is clear that the major cause is certainly the failure of the property to produce the $30,000 annual gross rental income which the listing had forecast and the partners had expected. If that amount had been attained then there would have been modest profits in 1992 and 1993, if capital cost allowance is ignored. It could not be said that the Appellant and her partners were sophisticated investors. Their investigation of this project before they committed themselves was sadly lacking. Nevertheless they, or at least the Appellant, entered into it with the intention and the expectation of making steady and significant profits on an annual gross rental income of $30,000. The shortfall in income came as a surprise to them.

The position taken by the Minister in reassessing the Appellant is to be found in the following paragraph from a letter written to her on June 4, 1996 by Revenue Canada Appeals Division:

Should the enterprise be found to have no expectation of profit, it is therefore not a source of income, and the deduction of expenses resulting in losses are [sic] prohibited by virtue of paragraph 18(1 )(a) of the Act.

In argument, counsel for the Minister modified this position somewhat. He asserted that the Appellant was in fact aware by the end of the second year, or earlier, that this project could not make money. By 1992, therefore, there was no expectation of profit on her part, or at least no reasonable one. That being so, the rooming house no longer constituted a source of income to the Appellant, and so she was not entitled to take her losses from it into account in the computation of her income. He relies on the decision in Brill v. Æ. [2] for the proposition that once the prospect of income is gone there is no longer a source of income, the losses from which may be included in the computation of income under section 3 of the Act.

Counsel for the Appellant based his argument squarely upon the decision of the Federal Court of Appeal in Tonn.3 This case, he says, is on all fours with Tonn. [3] The property is a purely commercial one, with no personal element. The investors were unsophisticated, with no prior real estate investment history. The circumstances which caused the losses were totally unforeseen by them. There is nothing out of the ordinary about the expenses which should arouse suspicion. It is simply an ordinary investment in real estate which went bad for reasons outside the control of the investors, who have suffered both operating and capital losses, and there is no reason to deny the Appellant the benefit of her share of the operating losses to be offset against her other income.

There is one paramount principle by which the Court must be guided in deciding cases such as this. It is found in the judgment of the Supreme Court of Canada in Moldowan v. /?. [4] For the purpose of computing her income under section 3 of the Income Tax Act, a taxpayer is entitled to deduct losses which derive from a business or property which is a source of income; in order for a business or property to be a source of income it must either produce a profit, or at least the taxpayer must have a reasonable expectation of profit from it. Whether or not the taxpayer has a reasonable expectation of profit must be determined objectively, looking at such criteria as the history of profit and loss from that source in prior years, the taxpayer’s training and ability to produce a profit from the source, the taxpayer’s plans for producing a profit, and the capability of the venture as capitalized of producing a profit, after charging capital cost allowance. In considering the potential for a business or a property to be a source of income, all the surrounding circumstances must be examined. Chief Justice Dickson made it clear that he did not consider this list of criteria to be exhaustive. Much has been written on the subject since then, but as the judgment of the Federal Court of Appeal in Mastri [5] shows, the principle laid down in Moldowan remains unchanged. No gloss has been added to it by the judgment of the Federal Court of Appeal in Tonn, although that judgment may sometimes be helpful in the specific application of the principle to particular cases.

As the judgment of the Federal Court of Appeal in Brill demonstrates, it cannot be said that once a source of income, always a source of income. That case was concerned with the right of the taxpayers to deduct the expenses, specifically interest, paid by them in relation to a residential property which had at one time been a source of income, at a time after the property had become the subject of judicial sale proceedings and it had become clear that it could no longer produce profit, either in that taxation year or thereafter. The Court, applying the principle in Moldowan, held that, after the point in time when it could no longer produce profit, the property was not a source of income, and its losses could no longer be taken into account for the purpose of section 3 of the Act.

To apply this principle to the present case I must answer the following questions:

1. When the Appellant and her partners bought the property, did they have a reasonable expectation of deriving profit from it?

2. If the answer is yes, did that reasonable expectation survive throughout the taxation years under appeal?

3. If it did not, when did it come to an end?

As to the first question, it was not argued by counsel for the Respondent that there never was a reasonable expectation of profit, nor do I think that it could be. The Appellant and her associates were, I think, naive in making the investment that they did without a much closer examination of the property and its income potential. Nevertheless they had some reasonable grounds for thinking that it could produce a profit. It was, at the outset, a source of income. It appears that the Minister has assessed the Appellant consistent with this view for the taxation years 1990 and 1991.

As to the second question, I believe that the property, by the time that it was sold under the power of sale, could not on any objective analysis reasonably be regarded as having the potential to produce profit, while continuing to support the burden of the three existing mortgages. It is in this respect that the present case is distinguishable from the facts in Tonn. In. that case the point was never reached, or at least it was not reached within the years under appeal, when the property could be said to have no hope of producing profit for the taxpayer in the foreseeable future. The Appellant, in her evidence, did not really dispute this, although she did disagree with the suggestion that this point had been reached by the time she consulted a lawyer at the end of September 1992. Just as the Court should not be too quick, in the non-personal-use cases, to find that an embryonic venture has no potential for profit, [6] so too it should not be too quick to find that a venture which once had that potential has lost it for all time. Businesses have set-backs. Often they recover from them. In Brillit was beyond any doubt that after the judicial sale proceeding began the Appellants would see no more profit from their MURB. In the present case there were danger signs at an early stage, but the partners persevered to try and turn their situation around. No doubt when the Appellant consulted her lawyer in September 1992, it was because she thought that the situation was grave. However the evidence demonstrates that her partners did not agree and I do not think that I can, on the evidence before me, say that they were totally wrong in that.

The gross rental income from the property for the year 1993 was $7,400. The interest expense in that year was almost $19,000. The Appellant’s evidence was that the reason that the gross rental income was so low was that the property was not rented, and thus produced no gross rental income, from July to December, 1993. In my view it must have been apparent on even the most optimistic view of the facts that this property was not going to yield any profit to the Appellant and her partners after the gross income fell to zero. I find that it was at the beginning of July 1993 that the property ceased to have any reasonable potential for producing profit in the hands of this group of investors, and bearing the existing mortgage debt. It was at this point, then, that it ceased to be a source of income for the purpose of section 3 of the Act. In the result, therefore, the Appellant is entitled to take into account in computing her income only her share of the losses sustained up to that time.

The appeals for the 1992 and 1993 taxation years are allowed, with costs, and the assessments for those years are referred back to the Minister for reconsideration and reassessment on the basis that the Appellant in computing her income for the 1992 and 1993 taxation years is entitled to take into account her proportional share of the losses for the property municipally known as 323 Jones Avenue, Toronto, Ontario for the 1992 taxation year, and her proportional share of the losses for that property for the months of January 1993 to June 1993, pursuant to section 3 of the Act. The appeal for the 1994 taxation year is dismissed.

The Appellant is entitled to only one set of costs.

Appeal allowed in part.