Date: 19980817
Docket: 96-256-IT-G
BETWEEN:
VIVIAN McGREGOR,
Appellant,
And
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
BOWIE J.T.C.C.
[1] These appeals are from reassessments for income tax for the taxation years 1991, 1992 and 1993. The Minister of National Revenue reassessed the Appellant for those years to disallow his claim to be entitled, in computing his income under section 3 of the Income Tax Act (the Act), to deduct from his other income certain losses which he claims to have sustained in the course of renting three houses owned by him. The losses disallowed are $53,138 for 1991, $47,089 for 1992 and $37,791 for 1993.
[2] The Appellant first purchases a house for the purpose of renting it in 1977 or 1978. He owned this house for about seven years as a rental property before selling it. He next acquired a rental property in 1988. Soon after, he acquired two more. The Appellant apparently claimed a rental loss in reporting his income for 1987, but the evidence does not reveal how this could be so if in fact he did not own a rental property between 1985 and 1988. This is only one of the aberrations in the Appellant’s evidence.
[3] The particulars of these purchases, so far as I can glean them from the evidence, are these. In 1988 the Appellant purchased 708 Mountain View Place, Newmarket. I shall refer to it as property #1. He paid $159,000, of which $124,000 came from a first mortgage at 12.5% per annum, and $24,000 from a second mortgage. The interest rate on the second mortgage is unknown. The Appellant paid some $15,000 from his own resources for the balance of the purchase price, and the other closing costs.
[4] In 1989 he purchased 640 Mountain View Place for $205,000 and $153,650 came from a first mortgage at 13.75% per annum and $25,000 from a second mortgage at 13.75% per annum. The Appellant paid approximately $26,000 from his own funds. I shall call this property #2.
[5] Also in 1989, he purchased 48 Seacliff Blvd., North York. He paid $239,000 for it, of which $167,300 came from a first mortgage at 12% per annum, and $31,000 came from a second mortgage at 18% per annum. The Appellant’s equity therefore was about $41,000 in this property. I shall call this property #3.
[6] The Appellant’s evidence concerning the rents he was able to charge for these properties was vague at best, as was his evidence as to the precise time for which they were not fully rented. It appears, however, that the monthly rental potential of the properties was about $1,650 for property #1, $1,500 for property #2, and about $1,600 for property #3 after the Appellant had paid to have a second rental unit created in the basement of it. The property taxes were about $1,500 per year for each. From these figures it is clear that none of these properties individually was capable of producing revenues sufficient to pay even the mortgage interest and taxes at the outset, even if the Appellant had been able to keep them rented for the full 12 months throughout the year.
[7] In fact, between 1987 and 1997 the Appellant claimed to have sustained losses totalling $425,235 from this so-called rental business. The smallest loss was $12,826 in 1996, but the following year it rose again to $29,738. I say that he claimed these losses, because the Minister did not accept that they had been satisfactorily established, and that was put in issue by the pleadings. No evidence of these expenses, other than vague oral assertions by the Appellant, was offered at the trial.
[8] The Appellant, throughout his evidence-in-chief, asserted several times that he had a plan to make a profit from these rental properties, and that according to that plan they would become profitable after about five or six years. At one point he testified that he had such a plan in writing, although, inexplicably, he had not brought it with him, nor apparently had he shown it to his counsel. I do not accept the Appellant’s statement that he had a business plan. I consider all of the Appellant’s evidence to be unsatisfactory in the extreme. Not only was it vague and unsupported by the documents which anyone carrying on a business would be expected to keep, but it was at times contradictory. At its highest, it was self-serving and uncorroborated in any way. On more than one occasion it was apparent that it was simply incorrect, either deliberately, or perhaps through carelessness. As a result I am left with no clear picture of the expenses actually incurred by him in connection with these properties. If they have been overstated by him, and as a result the losses are exaggerated, then he is the author of his own misfortune, because I have concluded, at least in part on the basis of the long and unbroken string of very large losses claimed by him, that the Appellant could have had no reasonable expectation of profit in connection with these properties, and that he consequently had no business, and no source of income therefrom.
[9] Mr. McCool suggested in argument that I should consider this case to be similar to Tonn v. Canada[1], wherein the Federal Court of Appeal found that the Appellants did in fact have a business, albeit an unprofitable one, and that their rental business could have been expected to show a profit, and would have done so but for unforeseen misfortunes. He asked me to consider that similar unforeseen circumstances were all that stood between this Appellant and a rosy financial future, and that he too, to use Linden J.’s words, should not be penalized for an honest error in judgment.
[10] In my view, there is no similarity between this case and Tonn. In that case the Appellants were reassessed for the years 1989, 1990 and 1991, in respect of a property which they had acquired in 1989. The Court found that they had a plan, although rudimentary. It also found that there were factors beyond their control which led to the failure to make a profit. In the present case I find that the Appellant had no plan by which he was going to make a profit from this venture. He was asked repeatedly by his own counsel to describe the plan, and could say nothing more than that he intended to make $5,000 or $6,000 per year after five years. He could say nothing about how that would be done, other than that he would pay down the mortgages and thus reduce his expenses. I shall return to this shortly.
[11] The Appellant, unlike the Tonn Appellants, has generated an unbroken string of losses for 11 years, according to a summary accepted by him and by his counsel during the course of the trial. Nor has he given any convincing evidence of unforeseen events which derailed his plan for profitability. He spoke in the vaguest possible terms of tenants leaving, and of having to have some tenants removed for non-payment of their rent. These, of course, are among the usual hazards of the property rental business. The evidence does not convince me that the Appellant was subject to these problems to any greater degree than is normal.
[12] I return to the Appellant’s stated intention to pay down the mortgages. First, there is no plan to indicate how much he had intended to pay down, or what the source of the funds would be. Second, there was no clear evidence as to how much was in fact paid down, or when. It appears that he did make some lump-sum payments on the mortgages from time to time, but the evidence is unclear, imprecise, and unsupported by a single scrap of paper. Third, the Appellant did indicate that at least some of the lump-sum payments on the mortgages came from the very substantial income tax refunds which the Appellant obtained as a direct result of the losses he claimed to offset against his income from a full-time factory job in the automobile industry. It may be that some of these amounts did in fact come from his paycheques, but it is a fair inference, I think, that the payments would not have been made but for the tax refunds, or if they were, they would have been of much smaller amounts.
[13] In Mohammad v. The Queen,[2] the Federal Court of Appeal addressed the subject of rental properties purchased by means of such high ratio financing as to render profit, at least in the initial years, impossible. Robertson J., for a unanimous court, said at pp 5505-6:
Frequently, taxpayers acquire a residential property for rental purposes by financing the entire purchase price. Typically, the taxpayer is engaged in unrelated full-time employment. Too frequently, the amount of yearly interest payable on the loan greatly exceeds the rental income that might reasonably have been earned. This is true irrespective of any unanticipated downturn in the rental market or the occurrence of other events impacting negatively on the profitability of the rental venture, e.g., maintenance and non-capital repairs. In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement. The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima facie, to satisfy the reasonable expectation doctrine. These are not cases where the Tax Court is being asked to second-guess the business acumen of a taxpayer whose commercial or investment venture turns out to be less profitable than anticipated. Rather these are cases where, from the outset, taxpayers are aware that they are going to realize a loss and that they will have to rely on other income sources to meet their debt obligations relating to the rental property.
After speaking of the specific facts relating to the financing in that case he went on to say at pages 5506-7:
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.
...
I would also point out that it is difficult to accept that interest being paid on money borrowed to acquire a capital property can be characterized as a "start-up" cost of the kind contemplated by this Court in Tonn, supra. This is not to deny that in other circumstances non-capital start-up costs may help explain, in part, why a taxpayer's rental venture was unprofitable. The reality is that it is much easier for taxpayers to satisfy the Moldowan test and claim a rental loss where the property was acquired without high-ratio financing:
[14] The evidence in the present case falls far short of discharging the burden of proof of which Robertson J. speaks there. I infer from the Appellant’s evidence that the primary source of funds to pay down the mortgages, to the extent that they were paid down at all, was the tax refunds to which I have referred. It is obvious that the Moldowan[3] burden of proving a reasonable expectation of profit cannot be satisfied by a plan which relies on the tax advantage of the losses in order to achieve profitability. In any event, even with the advantage of those losses for 11 years the Appellant has not been able to achieve profitability, nor is there any objective sign that he ever will.
[15] In addition to the history of profit and loss, and the ability of the business to show a profit as structured, and the ability and training of the taxpayer to engage in the business, referred to by Dickson J. in Moldowan, the courts have looked to such additional factors as the persistence of the factors causing the losses, the presence or absence of planning, and failure to adjust, when assessing whether or not an enterprise has a reasonable expectation of profit.[4] In the present case none of those factors can be invoked by the Appellant. I have referred already to the absence of anything that could be called a real plan. There is no evidence to suggest that the Appellant took steps to adjust to the difficulties he had encountered, other than the evidence to which I have alluded above about him making lump-sum payments on the mortgage.
[16] In short, the Appellant may well have hoped that profits would somehow materialize, but the assessment of the reasonableness of the expectation of profit must be done on an objective and not a subjective basis. No objective observer could have concluded during the years under appeal that these rental properties, or even any one of them, could be expected to show a true profit, after capital cost allowance is taken into account, in the foreseeable future.
[17] The appeals are dismissed, with costs.
Signed at Ottawa, Ontario, this 17th day of August, 1998.
"E.A. Bowie"
J.T.C.C.