Date: 20011010
Docket: 2000-2416-IT-I
BETWEEN:
KUMARA S. RACHAMALLA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor Judgment
Campbell, J.
[1] These appeals are from assessments for the 1990, 1991, 1992 and 1993 taxation years.
[2] The issue is whether the Appellant had a reasonable expectation of profit from his rental activities in respect to two properties that would entitle him to deduct rental losses and carrying charges in the 1990 to 1993 taxation years.
[3] The Minister relied on the following assumptions set out at paragraph 13 of the Reply to the Notice of Appeal as follows:
(a) the Appellant is a real estate agent and purchased the following two properties (the "Properties"):
Property #1
1 York Quay, 77 Harbourfront, Suite 2001, Toronto, Ontario.
The property was owned equally by the Appellant and Nandakumar Chari.
The Purchase agreement was signed on October 26, 1986 and the occupancy date was December 10, 1990.
The purchase price was $227,900.00 with a down payment of $77,600.00.
A vendor took back the mortgage of $150,300.00 at 10 3/4%.
The property was rented out since April 1990.
Property #2
120 Promenade Circle, Apt. 907, Thornhill, Ontario.
The property was fully owned by the Appellant.
The Purchase agreement was signed on January 18, 1989 and the occupancy date was December 10, 1990.
The purchase price was $288,250.00 with a down payment of $98,250.00 and a mortgage of $190,000.00 at 13%.
The property was rented out since January 1991;
(b) the Appellant claimed rental losses in respect of two Properties as shown in attached Schedule A;
(c) the total interest expenses consisted of the mortgage interest claimed on rental statements, and the investment carrying charges claimed under line 221 of the T1 returns;
(d) the rental income for the years under appeal did not cover the interest charges as the Properties were fully financed. The deposit amounts for the purchase of the Properties were borrowed from the Appellant's personal line of credit;
(e) the Appellant's rental and cash flow projections on the Properties were unrealistically optimistic as the interest expenses were understated and no capital cost allowance was included;
(f) rental expenses in excess of the amounts allowed by the Minister for the Properties were not incurred for the purpose of gaining or producing income from a business or property, but were personal or living expenses of the Appellant;
(g) the rental activities in the Properties were not carried on with a reasonable expectation of profit;
(h) in the alternative, the expenses claimed for the Properties in excess of the amounts allowed by the Minister were not reasonable in the circumstances.
[4] The Appellant obtained an MBA from the University of Toronto in 1969. He worked as an investment advisor with a number of firms until he was hired as a policy advisor by the Ontario government. He remained with the government until his retirement in 1994. In 1986 he became a licensed real estate agent and broker. He sold real estate part time and also taught courses in real estate licensing at a community college.
[5] Mr. Rachamalla purchased his first rental property, known as the Pony Mill property, around 1986 in the Scarborough area, in partnership with a Mr. Chari. This property was sold several years later at considerable profit. It was reported as a capital property.
[6] In late 1986, the Appellant again in equal partnership with Mr. Chari, purchased another property known and referred to here as the York Quay property. This property was a luxury downtown condominium unit in the Harbourfront area of Toronto. A parking unit was also acquired for this unit. The Appellant's evidence was that he purchased it for its location and its ability to attract good high-end tenants prepared to pay a higher rent.
[7] York Quay was under construction at the time of purchase. With four years of construction delays, the unit was not rented until February 1990. The cost of the unit plus parking area was $227,900.00. By September 1989, the Appellant and his partner owned 25% of the unit, having made numerous deposits to the vendor amounting to $57,080.00. They paid the further sum of $20,520.00 in February 1990, the closing date. The Appellant testified that his one-half share of these deposits came from his personal funds. He also stated that it was always their intention to operate this unit as a rental property. Initially the unit was leased at the anticipated high rental rate. The rental market in Toronto in the early 1990s, however, experienced a sudden dramatic decline with vacancy rates increasing.
[8] As soon as the Appellant acquired ownership and occupancy of the unit he attempted to rent it by listing and advertising with TREB, the Toronto Real Estate Board, to attract a quality tenant. The cost to do so was one month's rent. The unit was eventually rented, although for several months only in 1990. The unit was always rented to arm's length tenants. However the anticipated higher rental income could not be maintained due to the collapse in the Toronto real estate market in the early 1990s. With the construction delays of four years, maintenance fees for the unit and property taxes had increased. Mortgage interest rates had also increased substantially during this same period.
[9] At the date of closing, in 1990, the Appellant financed the balance of the purchase price ($150,300.00) through a vendor take-back mortgage. The monthly payments of over $2,000.00 included interest payments, maintenance fees, parking lot fees and estimated taxes. In March or April of 1991, the property was re-financed with Mutual Life. At this point the Appellant and his partner began an aggressive pay-down plan with respect to this mortgage. Short term mortgages were taken, generally one-year periods, which provided lower interest rates. Various lump sum payments were made and in 1994 the Appellant commenced weekly mortgage payments instead of monthly, again to accelerate pay-down of the mortgage. This again assisted in accelerating pay-down of the mortgage. In the mid 1990s the Appellant successfully negotiated the property taxes to a lower rate. In 1997 the mortgage was transferred to the Bank of Montreal to obtain a preferred rate of interest. While continuing to reduce the outstanding principal, the rental incomes were successfully increased.
[10] In 1996 this property began to show a profit and continues to do so today. The amount of profit has increased each year since 1996 from approximately $800.00 to over $6,000.00 in the year 2000. The mortgage was reduced from $155,000.00 in 1991 to $81,496.00 by the end of the year 2000. As pointed out by Appellant's counsel, this reduction represents a 50% cut in the mortgage balance within nine years during some of the worst real estate market conditions the Toronto area had experienced.
[11] Very detailed monthly logs or ledgers were maintained throughout the years. It is quite apparent from both the Appellant's evidence and the documentation provided at the hearing, that the bookkeeping system of income and expenses for this property was methodically maintained.
[12] In 1995, just two years after the Appellant was assessed, the gross rental income exceeded the projections that the Appellant made in 1986 when he first made a deposit on this property. The reported profits have increased significantly in each year after 1995.
[13] A second property was acquired in 1989, referred to as the Promenade property. It was purchased by the Appellant alone and was located in the North end of Toronto, an area experiencing great growth at that time. Again it was a luxury condominium which was expected to attract a higher calibre of tenant. At the time of purchase the rental market was rising and the Appellant's evidence was that he thought the trend would continue. According to the Appellant, he purchased this property to diversify his real estate investments, as this unit was located in an entirely different area of the city from the York Quay property.
[14] The Promenade property was under construction at the time of purchase in 1989. According to the evidence of the Appellant, in what was a rising real estate market, he anticipated reselling or flipping the property within one year of completion of the unit. However by the time the unit was ready for occupancy, the market of the early 1990s was in a state of collapse. The Appellant was forced to re-think his plans and as he put it: "I decided to rent the property and minimize the costs and minimize the damages so that I would be able to maintain the property". The fair market value of the property had declined to below its original purchase price.
[15] The purchase price of this property was $288,250.00, including parking. The Appellant paid deposits totalling $65,000.00 by October 1990 through his personal funds. At closing, an additional payment of $33,000.00 was made. Because of the market conditions, the Appellant listed the property for both rent and sale. Certainly the documentation produced supports the Appellant's evidence that when he purchased the property, he intended to resell quickly for profit. And the evidence is clear that this property was not 100% financed. Exhibits showed that the property was listed for sale in October 1990 for $289,900.00, again in August 1998 for $202,900.00 and in 1999 for $200,000.00. If he had been able to sell at a profit, he would have done so. This was supported by both the documentation and oral evidence.
[16] To assist in renting the property he again enlisted the services of TREB as he had done for the York Quay property. He screened tenants to obtain the best quality tenant, charged market rents which he increased regularly and followed an aggressive pay-down plan. He gave evidence that when the market improved he would sell but until then he had to rent the property and maintain it in a saleable condition. In late 1990, a vendor take-back mortgage for $190,000.00 was arranged at an interest rate of 13%. Rental of the unit commenced in 1991 and was always with arm's length tenants. In 1992 the vendor take-back mortgage was retired but due to the market conditions, the Appellant could not arrange for a mortgage for 75% of the purchase price to replace the vendor take-back mortgage being retired. The market value of the unit had declined according to the Appellant to $150,000.00 or less. He arranged a first mortgage in the amount of $120,250.00 with Laurentian Bank and a second mortgage in the amount of $45,000.00 with Beneficial Trust. In 1993, the second mortgage to Beneficial was retired and replaced with a private, arm's length loan (the Padmini loan), arranged through the Appellant's solicitor. This allowed the Appellant to reduce the monthly payments by approximately $150.00. In addition pre-payments could be made on the loan without penalty. This loan was retired in the fall of 1994, one year after the auditor's review. In the same year, the first mortgage to Laurentian was discharged and replaced with a mortgage to the Bank of Montreal. Accelerated weekly payments were commenced and the outstanding balance was reduced from $117,000.00 in 1994 to $94,808.00 in 2000. The original mortgage of $165,000.00 in 1990 had therefore been reduced by over 50%.
[17] The Appellant testified that his deposits on the Promenade property came partly from the sale proceeds of the first property the Appellant purchased in the 1980s known as the Pony Mill property and partly from a personal line of credit. As the interest rates on lines of credit in the early 1990s were so high, the Appellant re-financed his personal residence to pay off this line of credit and accommodate financing requirements for the two properties. When he re-financed his residence, the mortgage was increased from $140,000.00 to $270,000.00.
[18] Between 1990 and 2000, the Appellant significantly reduced carrying charges on the Promenade property according to spreadsheets prepared by the Appellant for the auditor. And by 2000 the payout on the mortgage against his personal residence had been reduced from $270,000.00 to $141,324.51.
[19] Again detailed logs were kept on a monthly basis regarding this property. The oral evidence of the Appellant was completely substantiated by the volumes of bank statements, summaries and other documentation introduced by the Appellant's counsel. The Promenade property began to show a profit by 1996, an amazing feat given the market conditions of the early 1990s and the rising interest rates. In addition the Appellant was the owner of a property he originally intended to sell but was now unable to do so, as the market value had fallen from $288,000.00 to $150,000.00 or less, shortly after the purchase.
[20] I commend both counsel in this case for their presentations and summations. Both presented clear and concise reviews of the case law in this area beginning with the Supreme Court decision in Moldowan v. The Queen, [1978] 1 S.C.R. 480; 77 DTC 5213 (S.C.C.). The principles which have emerged from the many cases in this area were clearly and concisely summarized by Associate Chief Judge Bowman of this Court in a recent decision, Donyina v. The Queen, [2001] T.C.J. No. 456. Reproduced from paragraph 9 of Judge Bowman's decision, they are as follows:
[9] I shall not quote from these cases or analyse them at length. It is, I think, sufficient to summarize some of the principles that they appear to establish.
1. Where there is no personal element the REOP test should be applied sparingly (Tonn, Keeping, Bélec and Walls). The absence of a personal element does not establish conclusively that the REOP principle cannot be invoked but such an absence is a factor that carries a great deal of weight (Mastri).
2. The Minister or the court should not, with the benefit of hindsight, second-guess the business acumen of a taxpayer who embarks upon a business venture in good faith (Keeping, Tonn, Nichol, Kuhlmann, Bélec and Smith).
3. The fact that a business or property is 100% financed is not in itself a reason for applying the REOP principle (Milewski, Mohammad and Saunders).
4. A taxpayer should be allowed a reasonable period of time to get the business established (Keeping). Such a period will vary with the circumstances and may well be lengthy (Milewski).
5. The REOP principle should not be invoked as a substitute for analysis. Before invoking REOP the assessor should examine the expenses to determine whether they are reasonable or for any other reason not deductible (Smith, Costello and Cipollone).
6. For an expectation of profit to be reasonable it has to be not "irrational, absurd and ridiculous" (Kuhlmann).
7. The fact that an investment or a business is motivated in part by tax considerations is not relevant in determining whether there is a business, nor is tax motivation in itself relevant in determining the deductibility of expenses if a business exists (Stubart Investments Limited v. The Queen, 84 DTC 6305) unless of course the Minister chooses to invoke the general anti-avoidance rule in section 245, in which case we are into a fundamentally different ball-game.
8. The initial question where losses are claimed and denied is whether they are personal or living expenses, the statutory definition of which includes the REOP test. If they are not, the REOP test must be applied with extreme care and the question becomes "Is there a business?" The existence of REOP is only one factor in that determination (Kaye).
9. Reasonableness operates both in the context of the existence of a business, where section 67 disallows the deduction of expenses to the extent that they are unreasonable, and also at the liminal stage of determining whether there is a business (Kaye).
10. If what is ostensibly a rental property was acquired and held in the course of an adventure in the nature of trade and it was reasonable to expect a profit on the resale the losses (i.e. carrying costs net of rentals received) should not be disallowed on the basis of REOP (Roopchan). The court should however examine with some care an ex post facto declaration that property that was carried for some years at a loss is part of a speculative venture in which the motive was resale at a profit. This is not something that one would expect someone readily to admit if the property were sold at a profit.
11. If the taxpayer has several rental properties, some yielding a profit and some a loss, it is improper to apply REOP to the losing properties and ignore the profitable ones. The entire investment picture should be considered (Smith).
12. When to start a business and when to abandon it are business decisions in which neither the taxing authorities nor the court should intervene (Nichol). Nonetheless if losses go on being incurred year after year for an inordinate length of time sooner or later one has to apply what I shall call the "Enough is enough" principle and decide that what might have been a viable business has, with the efflux ion of time, became hopeless and the best thing to do with it is to give it a decent burial. Nonetheless, a businessman's judgement to maintain a business must be treated with great respect.
[21] When I apply those principles which are applicable to the facts of this case, I can only conclude the obvious — that the Minister was simply incorrect in applying this test to the two rental operations belonging to the Appellant. The years in question are clearly start-up years for both properties. Both the York Quay and Promenade properties have been in a significant profit position since 1996. In fact the trend of increasing incomes and decreasing expenses was clearly established as early as 1994. Given the state of the Toronto real estate market in the early 1990s and the soaring interest rates, the Appellant's efforts turned both properties into profitable operations in a remarkably short duration. He established and pursued an aggressive business plan to pay down the indebtedness against both operations. His actions were those of an astute businessman. His plan was methodical and well structured. There was nothing haphazard in his approach to the unforeseen intervening circumstances which arose in the market shortly after his purchases. With the Appellant's extensive background in the real estate market, his projections in the 1980s at the time of purchase were both reasonable and realistic. They were based on market conditions at that time. However, the market changed, vacancy rates changed, interest rates increased as did maintenance fees and property taxes. All of these factors were beyond the control of the Appellant who then had to re-group and re-think his original plans. He was able to do so and shortly after the years in question the properties started to show profit.
[22] The projections made in 1986 with respect to the York Quay property were realistic and valid in relation to the market rates and conditions as they existed in 1986. The Appellant could not have predicted the drastic changes in interest rates and market conditions that were to occur in the early 1990s. The attempt by the Respondent to somehow show that these 1986 projections were unreasonable is a classic example of the use of hindsight by the Minister to second-guess the business decisions of the Appellant.
[23] Where there is no personal element, the case law is clear - the reasonable expectation of profit test is to be used sparingly. There was no personal element here. The Appellant clearly operated these properties as businesses. The facts so clearly point to the commerciality of the operations that to draw any other conclusion would be ludicrous. The Appellant used his expertise in the Toronto real estate market to search out the best locations, maximized exposure by paying an entire month's rent to advertise for tenants through the specialized Toronto Real Estate Network Board, screened tenants personally, kept the units rented during extremely difficult market conditions, established and followed an aggressive mortgage pay-down plan, cutting mortgages to half by the end of 2000, successfully appealed property taxes and reduced expenses. In addition the properties were not fully financed as stated in assumptions in the Reply. Some of the profit from the Pony Mill property sale was used as a deposit on the Promenade property and in addition the Appellant had alternate sources of financing. It also appeared from the auditor's evidence that she may have incorrectly assumed that the properties were 100% financed. And throughout the entire period meticulous records and logs were kept.
[24] To borrow a phrase used by Appellant's counsel - "If this isn't a business, then I don't know what is?" In Respondent counsel's submissions, she argued that "...there's no evidence of a concerted plan to make significant payments against the principal". To call this anything but a concerted plan or to suggest there was anything but significant reductions in all indebtedness associated with these operations is to have either slept through the presentation of the facts or to have blatantly ignored them.
[25] The Appellant made an alternative argument that if I concluded there was no reasonable expectation of profit for the Promenade property it could be characterized as an adventure in the nature of trade. I need not make any finding in this respect as the Respondent has been unsuccessful in persuading me that the Promenade property was so heavily financed that there could be no reasonable expectation of profit. The facts clearly support the opposite conclusion. His approach to this property was parallel to the York Quay property. The Appellant's stated intention at the time of acquisition was for resale, and this was supported by his later actions in listing it for sale in October 1990 and again in 1998 and 1999. The financial result would remain the same for the Appellant as he would still be entitled to deduct all carrying costs, including rental losses, if the property were characterized as an adventure in the nature of trade. (See Stremler and Jones v. The Queen, 2000 DTC 1757 (T.C.C.))
[26] The appeals are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment to allow the deduction of rental losses and carrying charges with respect to both properties for the 1990, 1991, 1992 and 1993 taxation years.
[27] If counsel wish, they may address the issue of costs in writing within 30 days of the date of the within judgment.
Signed at Ottawa, Canada, this 10th day of October 2001.
"Diane Campbell"
J.T.C.C.
COURT FILE NO.: 2000-2416(IT)I
STYLE OF CAUSE: Kumara Rachamalla and
Her Majesty the Queen
PLACE OF HEARING: Toronto, Ontario
DATE OF HEARING: June 1 and June 28, 2001
REASONS FOR JUDGMENT BY: The Honourable Judge Diane Campbell
DATE OF JUDGMENT: October 10, 2001
APPEARANCES:
Counsel for the Appellant: A. Christina Tari
Counsel for the Respondent: Sointula Kirkpatrick
COUNSEL OF RECORD:
For the Appellant:
Name: A. Christina Tari
Firm: Richler and Tari
Toronto, Ontario
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
2000-2416(IT)I
BETWEEN:
KUMARA S. RACHAMALLA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on June 1 and June 28, 2001 at Toronto, Ontario, by
the Honourable Judge Diane Campbell
Appearances
Counsel for the Appellant: A. Christina Tari
Counsel for the Respondent: Sointula Kirkpatrick
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1990, 1991, 1992 and 1993 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
If counsel wish, they may address the issue of costs in writing within 30 days of the date of the within judgment.
Signed at Ottawa, Canada, this 10th day of October 2001.
|
"Diane Campbell" |
J.T.C.C.