Bergeron v. R., [1999] 2 CTC 2022

Sarchuk T7.C.J.:

These are appeals by David P. Bergeron from assessments of tax for his 1992, 1993 and 1994 taxation years. Two issues were initially raised by the Appellant.

First, in computing his income for the 1992 and 1993 taxation years, the Appellant deducted net business losses in the amounts of $6,101.25 and $7,131.07, respectively. With respect to these losses, the Minister of National Revenue (the Minister) disallowed that portion described as business use of the home expenses in the amounts of $2,312 and $1,356. The Appellant says the denial of these expenses is not in issue, rather he seeks to have the Court cancel or waive interest and penalties on the basis that they arose because of the actions of Revenue Canada, i.e. processing delays. This portion of the appeal was abandoned by the Appellant at trial.

Second, in computing his income for the 1993 and 1994 taxation years, the Appellant deducted net rental losses in the amounts of $5,813.66 and $5,704.02, respectively. These losses were disallowed on assessment. Thus, the sole issue before this Court is whether the expenses with respect to the rental property were incurred for the purpose of gaining or producing income within the meaning of paragraph 18( 1 )(a) of the Income Tax Act (the Act).

The following facts are not in dispute. In April 1993, the Appellant and his wife purchased a condominium (the property), as Joint Tenants, in Orlando, Florida, a vacation resort area. The price paid was $21,300(US) and was fully financed by increasing the amount owing on a mortgage on the home they both owned in Kingston by the amount of $27,688.44(Cdn.).

In the 1993 and 1994 taxation years, the Appellant reported gross income and net rental losses as follows:

The Appellant claimed 100% of the net losses incurred with respect to this property in the taxation years under appeal.

The Minister disallowed the said net rental losses on the basis that they were not incurred for the purpose of gaining or producing income from a business or property. The Minister further took the position that, in any event, certain items claimed by the Appellant in computing his net income may not be deducted. These are a capital cost allowance (CCA) claim with respect to the cost of the property in the amounts of $1,070.12 and $1,027.32 in 1993 and 1994, respectively, and a claim in 1993 for travel expenses in the amount of $867.66.

The Minister’s position is that these items cannot be deducted because:

(a) in the case of the CCA, such a deduction is precluded by subsection 1100(11) of the Income Act Tax Regulations (the Regulations); and

(b) the travel expenses were personal or living expenses of the Appellant within the meaning of paragraph 18( 1 )(A) of the Act;

The Respondent further takes the position that since the property in issue was jointly owned by the Appellant and his wife, was jointly managed, and since the cost of upkeep and maintenance expenses were incurred by both, the Appellant is only entitled to 50% of the net rental losses for the 1993 and 1994 taxation years in the event he is successful in his appeal.

The only witness to testify was the Appellant. He said that at the relevant times, he was (and still is) employed by the Ministry of Transport (Ontario). His wife is a secretary in a law office. They have two pre-teen children. Concerned about the cost of living and their future, they became involved in several ventures in an effort to supplement their incomes. She began to sell Mary Kay cosmetics while he chose to become an Amway distributor. Following the failed real estate venture (the subject of this appeal) and in anticipation of a public service strike, the Appellant constructed and operated a “chip truck” which he ran “successfully” for over a year, abandoning it only when his job was “more secure”.

The property was brought to his attention by a co-worker whose brother was interested in selling. The Appellant spoke to him and then to the manager of the complex (the manager). Their interest was piqued and in March 1993, the Appellant travelled to Florida to examine the property. While there, he compared it to other units in the complex, spoke to real estate agents and canvassed other sources to compare prices and rents. The manager advised him that reservations were in hand for the unit for a period of three weeks in the fall of that year. As well during his visit, he met an American couple (the Ponds) who had previously rented other units in the complex. They indicated an interest in the unit and paid the Appellant a $150(US) reservation deposit for a three and one-half to four month period commencing January 1994 at $1,000(US) per month.

Satisfied with his inquiries and secure in his belief that he had a full- time rental every winter (the Ponds), the Appellant and his wife proceeded with the purchase. He felt that he had made sufficient contacts and had an arrangement with the manager (who was registered with the Florida Tourist Department) to find additional tenants for him. Following the acquisition, he commenced advertising primarily by word of mouth and by putting up posters at his place of employment and other offices. He says a number of people showed interest but, as a result of the Pond arrangement, he was unable to accommodate them. The Appellant also testified that at some point of time, he and his wife drove there “to do some renovations since the unit was somewhat rundown”.

At or about the beginning of December 1993, Pond telephoned the Appellant, advised him that his wife had been in an accident and could not travel and as a consequence they were giving up their reservation. The Ap- pellant immediately advised the manager that the unit was available and approached several individuals who had earlier shown an interest, all to no avail.

In the spring of 1994, the Appellant discovered that the manager was also the owner of a number of units in the complex and freely admitted that he “filled his own” first. Notwithstanding these problems, the Appellant said that:

...I believe at that time we still tried, once we started recalculating, thought maybe Mr. Pond would come back after his wife’s health had improved and decided to keep it for that year and started renting it out for the season of ’95. So ’94 was basically a write-off year I [1]

Towards the end of 1994, they started receiving bookings for the 1995 season but none were long-term. The manager sent out flyers and the Appellant himself advertised in the Kingston newspaper. He also continued to post bulletins at work and in other government employment centres in Ottawa and Almonte. These produced a number of inquiries and “that’s where I started getting the majority of what rentals I did have”.

The Appellant testified that he and his wife calculated that a profit would be made from the outset. This assumption was based on rent from the Ponds in the amount of $3,750(US), the three weeks which had been booked by the previous owners and a further reservation for one week which the Appellant had obtained, all at $300(US) per week. As a result, he said, they expected to “clear” approximately $1,000(US) the first year.

The Appellant was unable to recall the exact number of weeks which were booked in 1995 but says that while there was no profit, he thought the operation was breaking even. At another point, he testified that the gross income in 1995 was $4,000(Cdn.) which, by his calculations, represented rental for 12 to 13 weeks. No further information to support his conjecture was adduced and such records as were available to him provided little assistance.

For the period in 1996 prior to the sale, the rental income reported was $1,865(Cdn.) and the expenses $1,166.69(Cdn.). The Appellant made note of the fact that in the first six months of that year they made a profit of $700. However, it became evident in the course of further examination that he had failed to include in his calculation a number of items of expense including mortgage interest (approximately $2,300 in 1995), and certain other fixed costs.

The property was sold in June 1996 at a loss. According to the Appellant, the decisions to sell it was taken because:

Once we found out that the Ponds were no longer interested in renting and the fact that our property manager, which was a separate company, had actually the majority of units in there, that it wasn’t going to be profitable, then we decided to take that money and reinvest it somewhere else.

Conclusion

At issue in this appeal is the right of the Appellant to deduct for tax purposes his share of rental losses from other income pursuant to the provisions of the Income Tax Act. Paragraphs 18(1)(a) and (h) of the Act provide: 18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay of expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(h) personal or living expenses of the taxpayer, other than travelling expenses incurred by the taxpayer while away from home in the course of carrying on his business;

The Appellant takes the position that the property was not acquired for use as a vacation property or personal use. Furthermore, he contends that his initial analysis of the commercial viability of the acquisition justifiably led him to conclude that profitability was reasonably assured. The thrust of the submissions made on the Appellant’s behalf was that the expectation of profit was not so unreasonable as to raise any suspicion or question and that since no personal element was in evidence the Appellant’s judgment as to the profitability, honestly held, ought not to be questioned. [2]

In order to succeed, the Appellant must demonstrate that the expenditures in issue were made for the purpose of gaining or producing income from the business or property. From this flows the requirement that the Appellant must in fact be carrying on a business within the meaning of the Act. In Moldowan v. R.,° [3] Dickson J. (as he then was) considered what constitutes the operation of a business and concluded that “although originally disputed, it is now accepted that in order to have a ‘source of income’ the taxpayer must have a profit or a reasonable expectation of profit”. Source of income, thus, is an equivalent term to business. Dickson J. then further observed that:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive....

Thus, if as a matter of fact a taxpayer is found not to have a reasonable expectation of profit, then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss.

What I must determine is whether the evidence clearly establishes that the Appellant (and his wife) were engaged in a business enterprise, and more specifically, that their expectations of profit were not unreasonable in the circumstances. To discharge the onus, the Appellant need not demonstrate that in buying the property he acted on the basis of some sophisticated analysis or advice regarding the prospects of rental income vis-à-vis rental expenses. However, he must put some evidence before the Court from which it can be objectively concluded that his conduct was that which could be expected of a reasonably prudent person becoming involved in a commercial undertaking designed to earn profit from renting real estate.

In my view, the Appellant’s deduction of losses from this venture must be disallowed. I reach this conclusion not because the taxpayer made a poor business decision, rather I am satisfied that the “expectations of profitability” were patently unreasonable. As was observed by Bowman T.C.C.J. in Cheesemond v. R.: [4]

Nonetheless, there must be sufficient of the indicia of commerciality to justify the conclusion that there is a real commercial enterprise being conducted....

That is not the case in the present appeal.

First, the acquisition of the property was financed completely by borrowed funds. The Appellant’s testimony with respect to their plans for reducing the principal amount of the loan was: “Well, as income - - that is when we got money, assuming we would get money, we would start paying that down”. He conceded that their only strategy was to use the rental income from the property to pay down the mortgage. In Mohammad v. Æ., [5] Robertson J.A. said:

The above analysis is to the effect that there can be no reasonable expectation of profit so long as no significant payments are made against the principal amount of the indebtedness. This inevitably leads to the question of whether a rental loss can be claimed even though no such payment(s) were made in the taxation years under review. I say yes, but not without qualification. The taxpayer must establish to the satisfaction of the Tax Court that he or she had a realistic plan to reduce the principal amount of the borrowed monies. As every homeowner soon learns, virtually all of the monthly mortgage payment goes toward the payment of interest during the first five years of a twenty to twenty-five year amortized mortgage loan. It is simply unrealistic to expect the Canadian tax system to subsidize the acquisition of rental properties for indefinite periods. Taxpayers intent on financing the purchase of a rental property to the extent that there can be no profit, notwithstanding full realization of anticipated rental revenue, should not expect favourable tax treatment in the absence of convincing objective evidence of their intention and financial ability to pay down a meaningful portion of the purchase-money indebtedness within a few years of the property’s acquisition. If because of the level of financing a property is unable to generate sufficient profits which can be applied against the outstanding indebtedness then the taxpayer must look to other sources of income in order to do so. If a taxpayer’s other sources of income, e.g., employment income, are insufficient to permit him or her to pay down purchase-money obligations then the taxpayer may well have to bear the full cost of the rental loss. Certainly, vague expectations that an infusion of cash was expected from Aunt Beatrice or Uncle Bernie will not satisfy the taxpayer’s burden of proof. In practice, the taxpayer will discharge that burden by showing that significant payments were in fact made against the principal indebtedness in the taxation years closely following the year of purchase.

A serious question arises as to the ability of the Appellant to carry the required financing. I note that in years 1992, 1993 and 1994, he reported employment income of $37,400, $36,900 and $38,950, respectively, from which he sought to deduct business losses (Amway) in the amounts of $6,100, $7,131 and $4,790, respectively. There is no evidence before the Court as to his wife’s income from her employment nor whether she was earning sufficient income from her outside source to produce profits.

I am also unable to accept without question the Appellant’s testimony that he and his wife were not motivated at all by the property’s potential use as a vacation site. While this is not a factor of substantial significance in my conclusion, its existence cannot be ignored. In the short period of ownership, the Appellant went to the property three times by himself, for the sole purpose, he says, to do renovations and cleanup. He also travelled there twice with his wife and twice with the children as a family but insisted that these trips were not purely an excursion but were %o pleasure and work.

As to the purchase of the property, it is clearly understood that the place of the Court is not to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated. [6] However, as was observed by Linden J.A. in Tonn v. /?.: [7]

...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....

In his assessment of the commercial viability of the project, several factors appear to have been overlooked or glossed over. First, the Appellant was aware that potential clients including the Ponds, expressed their interest in the property by way of a reservation request. The form utilized by the Appellant states that a reservation deposit of $100(US) is due with the request and also clearly states that a cancellation 30 days or more prior to the day of checking in assures the client a full refund of the deposit. There is no evidence that the Appellant sought any information as to the average rate of cancellations which, one might assume, would readily have been available from the manager he hired. Second, it is also a fact that the manager was entitled to 25% of any rentals arranged by him. Third, with respect to the Appellant’s initial assumption that a profit would be made in the first year, it should be noted that the “income” he utilized in his calculation was a combination of projected gross revenues reflecting the latter part of 1993 and the first part of 1994. Last, although he said that some inquiries were made with respect to the cost of operating the unit, he conceded that no “profit analysis” of any nature was done. He now says that in retrospect, he should have “done a written business plan” with the assistance of professionals.

It is clear from the Appellant’s evidence that the property was unlikely to generate sufficient profits to cover the interest costs of the monies borrowed. This coupled with the absence of any evidence of their financial ability to pay down a meaningful portion of the debt within a reasonable period of time leads me to conclude that there was neither a reasonable assessment of the commercial viability of the property nor was there any form of realistic plan to reduce the principal amount of the borrowed monies. These factors as well as the personal use element are inconsistent with the existence of a genuinely viable rental operation.

Had I concluded otherwise, I would have found: (a) that subsection 1100(11) of the Regulations preclude the Appellant from deducting capital cost allowance; and (b) that the Appellant would be entitled to only 50% of the net rental losses for the taxation years in issue.

The appeals are dismissed.

Appeal dismissed.