Tax Court of Canada Judgments

Date: 20000619

Docket: 1999-334-IT-I

BETWEEN:

SHARON CRATE,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Sarchuk J.T.C.C.

[1] These are appeals by Sharon Crate from assessments of tax with respect to her 1994, 1995 and 1996 taxation years. In computing income for those years, the Appellant deducted the amounts of $8,534, $10,005 and $9,772, respectively, as rental losses. The Minister of National Revenue disallowed the claimed deductions.

[2] The property in issue is located at 4463 Baseline Road, Sutton West, Ontario (the property) and was acquired in June 1989 at a purchase price of $525,000 as the future principal residence of the Appellant and her spouse, Barry Thomas Crate. The property was described by the Appellant as a two-storey house with a main floor level and a basement level which, although connected by a staircase were in fact separate living units. The main level consisted of three bedrooms, a kitchen, living room and two bathrooms while the basement level had two bedrooms, a bedroom/den, living room, kitchen and bathroom. The laundry room, furnace area and a storage/workroom were also located in the basement level. The property also had an in-ground swimming pool and a "storage cabin + property storage (outdoor storage)".

[3] According to the Appellant, the property was initially purchased with the intention of utilizing the upper level as the family residence and renting the basement level. At that time, the Appellant and her family were residing in a home in another part of urban Toronto which they planned to sell. However, shortly after the purchase of the property, there was a downturn in the real estate market as a result of which both properties were listed for sale with the intention of disposing of whichever one sold first and living in the other. In the meantime, commencing in the fall of 1989, both units in the property were rented. In 1990, the Appellant and her spouse earned gross rent in the amount of $24,800, incurred an interest expense of $11,137 and total expenses of $23,423 producing a net rental income of $1,367 of which each reported 50%.

[4] The initial purchase price of the property was financed by way of a first mortgage in the amount of $200,000. The Appellant testified that her husband was self-employed and looked after the children while she was employed fulltime. This caused problems with respect to mortgage financing and in particular, required them to renegotiate the first mortgage on an annual basis. She also said they had to turn to mortgage brokers for that purpose thereby incurring additional costs. In 1991, the first mortgage was renewed at a higher rate of interest and a second mortgage in the amount of $40,000 was obtained from another lender. As a consequence, although the gross rental incomes in 1991 were $22,900, expenses amounted to $32,649 (with interest forming almost 2/3 of that amount) creating a net loss of $9,794 of which she claimed 50%.

[5] At some point of time in 1992, their "old home" was sold. In August of that year, the existing lease for the main level of the property expired and the Appellant and her family moved in. As well, prior to mid-summer of that year, the family renting the downstairs unit moved out. The Appellant said that at about the same time health problems and financial difficulties forced her in-laws to sell their home and as a result, they took occupancy of the basement unit at a rental cost of $600 per month. In 1997, a rift developed between the Appellant's family and the in-laws allegedly following a request for increased rental payments. The in-laws left in October and efforts were made to find a new tenant without success until the latter part of 1998 when it was rented for the balance of that year and throughout 1999 at $600 per month.

[6] From 1992 to 1997, the Appellant reported rental income expenses and losses from the property as follows:

Year	Income	Interest Expenses	Total Expenses	Rental Portion	Loss	Appellant's Portion 100%
1992[1]	$13,150	$30,097	$34,667		$21,517	$21,517
1993	7,200	23,347	33,406	16,703	9,503	9,503
1994	7,200	20,308	31,468	15,734	8,534	8,534
1995	7,200	22,471	34,410	17,205	10,005	10,005
1996	7,200	21,531	33,945	16,972	9,772	9,772
1997	4,800	15,391	25,023	12,511	7,711	7,711

With respect to the 1998 and 1999 taxation years, the Appellant maintains that the tenant attended to snow removal, grass cutting and so forth sparing the Appellant the cost of those services. She also indicated that with respect to the expenses incurred during this period, 65% was allocated to personal use which permitted her to show a slight profit in 1999.

Year	Income	Interest Expenses	Total Expenses	Rental Portion	Loss	Appellant's Portion 100%
1998	1,200	2,878	3,858	1,224	24	24
1999	6,000	15,769	23,250	5,963	37[2]	37

[7] It is the Appellant's position that the rent charged during the taxation years in issue was fair and reasonable considering the location of the property which was essentially rural and lacked the services generally available in a more urban area. More specifically, she observed that there were no sidewalks, street lights, water, sewers, cable TV and/or local transit and that the only advantage of renting to in-laws was that they were more forgiving or accepting of the shortcomings of the rental unit in question. The Appellant also argued that the rent paid by the in-laws was comparable to rental rates advertised in local newspapers which ranged from $400 to $700 per month. She contends that considerable efforts were being made in order to realize a profit and in particular steps had been taken to cut expenses. She also maintains that in her opinion everything pointed to the high cost of mortgages as being the main reason for consistent rental losses and argues that as mortgage payments decrease, the rental property will produce a profit.

[8] In order to succeed the Appellant must demonstrate that the expenditures in issue were made for the purpose of gaining or producing income from a property. Subsection 9(1) of the Act defines the concept of business income by reference to profit while subsection 18(1)(a) of the Act contains specifically prescribed statutory limitations on expense deductions. In particular, the latter sets out a general prohibition which denies a deduction unless the amount is paid or incurred for the purpose of gaining or producing income. Paragraph 18(1)(h) specifically limits the deductibility of personal or living expenses, which are defined in subsection 248(1) of the Act to exclude expenses in connection with a property unless it is maintained in connection with a business carried on for profit or with a reasonable expectation of profit.

[9] In Moldowan v. The Queen,[3] the following criteria for determining whether a reasonable expectation of profit existed were proposed by Dickson J. (as he then was):

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. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews (1974), 74 DTC 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

[10] A number of factors lead me to conclude that the Appellant's position is not well-founded. She claims that the lack of profit was due almost entirely to the high cost of mortgage interest. That may be in some measure correct, however, it is something which the Appellant must have been aware of prior to her embarking on this venture.[4] She was cognizant of the fact that they were considered high risk borrowers, were not able to obtain favourable interest and payment terms and would likely be required to incur mortgage broker's fees to obtain financing. Notwithstanding these facts, no income expense projections appear to have been made even though on the facts available to them it should have been apparent that profits were unlikely. The Appellant's observation that "the rent charged did cover the 'usual' expenses, granted, with the exception of the mortgage interest (I don't feel that we should be penalized or disqualified from the rental operation scenario simply because of a large mortgage resulting in large amounts of interest paid)" is indicative of the approach taken. In Mohammad v. The Queen,[5] Robertson J.A., speaking for the Court made the following observation:

... 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. ...

In this context, it is necessary to note that the Appellant explicitly stated in the course of her testimony that the area does not justify high rents and that therefore even reaching a break-even point was difficult. I also note that the Appellant observed that a large mortgage alone does not justify charging unusually high rent for the location in which they live. This fact was known to her when they purchased the property ostensibly for its capacity to produce rental income.

[11] While it is inappropriate for a Court to second-guess or to substitute its business judgment for that of a taxpayer where circumstances strongly suggest that a personal motivation existed and where the expectation of profit is so unreasonable as to raise a suspicion, the taxpayer is required to demonstrate that there are sufficient of the indicia of commerciality to justify her position that a business is being conducted. I am satisfied that the acquisition of the property in issue involved a personal element. The Appellant's contention that the amounts paid by her in-laws reflected going market rates must be viewed in the context of a statement she made in a Rental Questionnaire[6] where she observed that for the years in question their rental rate was established by taking into consideration several factors including the in-laws' financial situation and the "resultant amount of disposable income they had". She also noted that since these were her husband's parents, they felt a sense of obligation and responsibility to offer them "the chance to our downstairs".

[12] On balance, I am satisfied that during the taxation years in issue the Appellant was not engaged in a commercial enterprise. The facts clearly indicate that a personal other than business motivation existed. As well, an examination of the rental income and expenses demonstrates beyond a doubt that her expectation of profit was quite unreasonable in the circumstances. The appeals are dismissed.

Signed at Ottawa, Canada, this 19th day of June, 2000.

"A.A. Sarchuk"

J.T.C.C.

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