Goch v. R, [1999] 4 CTC 2269 (Informal Procedure)

Bonner T.C.J.:

The Appellant appeals from assessments of income tax for the 1992, 1993, 1994 and 1995 taxation years. The appeals are governed by the informal procedure of this Court. In making the assessments in dispute the Minister of National Revenue (“Minister”) disallowed the deduction of amounts claimed by the Appellant as rental losses. The property rented consisted of rooms in a house in which the Appellant resided. The house was located at 128 Glenmore Road, Toronto, Ontario.

The assessments were made on the basis that the rental operation was not a source of income, that is to say, the Minister found or assumed that the Appellant had no reasonable expectation of profit from the rental of rooms during the years in question.

The property was acquired by the Appellant pursuant to an agreement of purchase and sale entered into in April 1989 and closed in June 1989. The building consisted of a basement, main floor and second floor. There were three bedrooms located on the second floor. Initially the Appellant occupied one of the bedrooms and rented or attempted to rent the other two bedrooms. The basement was unfinished.

The purchase price was $220,000 of which $100,000 was paid by the Appellant from his own funds and the balance was borrowed on security of a mortgage. The Appellant testified that at the time of the purchase the market was strong and properties were appreciating in value. The Appellant stated that he was hoping for capital appreciation and income from the rental of rooms. He indicated further that the nature of the wiring and plumbing on the second floor and the location of the stairs made the building suitable for division into flats.

Before 1989 the Appellant had limited experience with the rental of another property. He said that before buying 128 Glenmore Road, he investigated market rents by looking at classified ads. He stated that there were bidding wars at the time and key money was being paid by individuals who wished to obtain rental accommodations. The Appellant testified that at the time of the purchase he prepared a projection of the financial results of the rental operation. He produced a copy of the projections which showed that losses were anticipated in the years 1989 to 1992 and that a small profit was expected in 1993. The projections assumed that the two rented bedrooms would fetch progressively higher monthly rents ranging from $350 each in 1989 to $450 each in 1993. It was further assumed that total annual costs of taxes, utilities, mortgage interest, insurance and maintenance would rise from $12,150 in 1989 to $15,414 in 1993. The projections reflected an assumption that two thirds of such costs would be attributable to the rental operation.

Rental operations prior to the years now in question did not turn out to be profitable. The Appellant reported rental losses of $430.49, $12,164.97 and $10,584.08 for the years 1989, 1990 and 1991 respectively. Reported gross rents for those years were $2,960, $4,150 and $3,600. Thus the actual results from the first two and one half years of operation suggested that the Appellant might expect to experience difficulty in generating even half of the gross rents which had been projected by him. Also, experience up to the end of 1991 suggested that actual expenses were significantly greater than had been projected.

The Appellant explained that up to February or March of 1990 actual rents were close to those which had been projected. At that point the recession began to have an adverse effect on the rental market. Good tenants left and the rents which the Appellant was able to charge decreased. As well, he explained, the property was not close to the subway and did not have good parking. The Appellant’s efforts to respond with increased advertising were met with little response.

In 1992 the Appellant revised his plans. He decided to construct a new apartment on the second floor. This, he thought, would enable him to attract a better class of tenants. He prepared a new set of financial projections. He failed however to proceed promptly with the construction of the new unit. In 1993 renovations commenced in the basement. In 1994 those renovations were completed and the Appellant occupied the newly renovated space as his personal bedroom. The Appellant’s move from a bedroom on the second floor to the basement released space for the construction of the new apartment on the second floor. The slow paced renovation and construction work appears to have added to the difficulty of attracting and retaining tenants.

The Appellant called Brian Fulcher to give evidence as an expert witness on the subject of the commercial viability of the Appellant’s rental operation. Mr. Fulcher has considerable experience in the management of small residential properties and he has inspected approximately 300 such properties for purposes of providing advice to persons intending to develop them as investments. He personally owns three rental properties. In preparing his opinion Mr. Fulcher inspected 128 Glenmore Road and he reviewed the projections which had been made by the Appellant. He testified that:

i) it normally takes four or five years for a new residential rental property to become profitable;

ii) the Appellant’s 1989 projections, though realistic, were not realized because in 1990 there was a major recession in the rental real estate market;

iii) rents charged by the Appellant were low, probably because the

Appellant reduced rates in order to secure reliable tenants;

iv) the Appellant’s plan to convert the building to self-contained apartments was an appropriate way to deal with the short-fall experienced by him.

I do not find that the evidence of Mr. Fulcher was helpful. His experience seems to have been concentrated more in the area of self-contained dwelling unit rentals than in room rental operations. Furthermore, in the absence of evidence as to the factual basis for Mr. Fulcher’s conclusions, I am not persuaded that the Appellant’s 1989 projections were realistic. On the revenue side, Mr. Fulcher did not say whether the accommodation product which the Appellant had to offer was simply the use of a bedroom or the use of a bedroom together with the right to share common areas of the house equally with other occupants including the Appellant. The nature of the accommodation offered would, it seems to me, affect the rents which might be expected. It was said that the recession may have dampened the rental market but it is not clear on the evidence that there was ever any objective basis for expecting to receive rents at the levels anticipated by the Appellant. On the expense side it is impossible to determine whether the projected allocation of costs pertaining to the house as a whole such as mortgage interest, taxes and insurance was right without a clear understanding of the percentage of such costs attributable to the rental operation. It would be wrong to attribute one third of overall costs to each bedroom unless the rental of each bedroom carried with it an equal right to share the common areas. There is no suggestion that Mr. Fulcher analyzed this aspect of the projections.

The leading case on the point now in issue is the decision of the Supreme Court of Canada in Moldowan v. R. (1977), 77 D.T.C. 5213 (S.C.C.). There Dickson, J. as he then was, speaking for the Court said at page 5215:

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...

He added:

...In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts...

As the word “expectation” suggests the test is not one of hindsight. In Mas- tri v. À. (1997), 97 D.T.C. 5420 (Fed. C.A.) Robertson, J.A. said at page 5423:

...it is not the place of the courts to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated...

As already mentioned I am not persuaded on the evidence that in 1989 there existed an objective basis for an expectation that the rental operation would be profitable. The experience of the Appellant between the time when rental operations were started in 1989 and the commencement of 1992 suggests that as the Appellant entered the years under appeal there was every reason to believe that the rental operation could not be carried-on profitably. This is a case in which the Appellant seeks to deduct losses from the rental of two bedrooms in his three bedroom personal residence. The presence of the personal element requires careful scrutiny of the evidence in order to ensure that the rental operation is commercial in nature and not simply an undertaking designed to reduce the carrying costs and expenses of a property which is primarily a personal residence. In my view, the evidence does not meet the test.

It is not enough to say that new rental operations normally suffer from losses for a few years. Care must be taken to distinguish between the losses of the first few years of a commercial operation and losses which occur in the first few years of an operation which at no time had any reasonable prospect of yielding a profit. The start-up period for newly founded commercial operations does not start until the operation is so structured, organized and financed that it is reasonably capable of yielding a profit in due course. [1]

The appeals will therefore be dismissed.

Appeal dismissed.