McArthur J.T.C.C.: — The appeals of Rajesh Monga were heard in Toronto under the Informal Procedures of this Court on common evidence with the appeals of Neera Monga and Edmundo Sanchez.
The issue is the deductibility of rental losses incurred by Mr. Monga in the 1990, 1991 and 1992 taxation years. The amounts of the losses claimed by him are $26,685.83 in 1990, $33,425.06 in 1991, and $30,647.64 in 1992.
The Appellant purchased several properties. Some were purchased with partners and others were purchased by the individual Appellant alone. While some facts are in common, some facts are attributed to the Appellant alone. A determination of the issues is made individually in separate judgments. All three Appellants bought and sold or retained residential properties within a short period of time. The ownership was different in most instances and each Appellant’s purchases are dealt with separately.
One Maritza Ratti had been associated with the three Appellants in some common transactions. Her appeals were disposed of at the outset of the proceedings.
The Appellant purchased 42 Large Crescent, a residential unit, with Miss Ratti and Mr. Sanchez for $113,000.00 in 1987 and sold it for $192,500.00 in 1990.
He purchased a residential unit at 607-30 Thunder Grove for $88,300.00 in 1987 and sold it in 1990 for $145,000.00.
In June 1988, he and Anil Sethi purchased a two-bedroom condominium located at 1407 - 1900 Sheppard Avenue East, North York for $152,500.00.
In March 1990, he and his spouse purchased a one-bedroom condominium located at 2104 - 25 Grandville Street, Toronto for $169,900.00. Although he claimed 100% interest, he stated that she was holding a 50% interest in trust for him.
The recorded income and losses are as follows:
| (v) 2205-24 Wellesley Street | Claimed, 1991 | Claimed, | |
| 1992 | |||
| interest | $8,156.00 | NIL | |
| (plus) | other expenses | $20,021.87 | $31,400.45 |
| total expenses | $28,177.87 | $31,400.45 | |
| gross rental income | $10,350.00 | $12,000.00 | |
| (minus) | |||
| net loss | $17,827.87 | $19,400.45 | |
| muttiplied by) | % ownership | 100% | 100% |
| pro-rated net loss | $17,827.87 | $19,400.45 | |
The Sheppard Property would generate rental income of $1,200 per month. Based on similar projections above, it was expected to generate a profit in 1991. Similarly, the Grandville Property could initially be rented for $1,300 per month and it was projected to generate profit beginning in 1993. Finally, based on MLS date available from the Toronto Real Estate Board, it was estimated that the Wellesley Property would be in a profitable position beginning in 1994 when the initial rent was set at $1,400 per month and increased at a rate of approximately 5%.
On the basis of income and expense projections, the overall rental operations was considered viable and had a reasonable expectation of profit. It was clear at the time of purchase that there was an anticipation of positive cash flows from the investments after the initial start up period and thus, there was an expectation of profit. It was also expected that the rental income would be sufficient to cover operating expenses, and realized profits would be used toward the repayments of borrowed money. Moreover, the investments were intended to be long term with the prospect of income gain both from rental income and the appreciation of property value.
It was unfortunate for the Appellant that the profit potential from this venture did not materialize for the following facts and reasons:
1. Rental revenues fell short of what were expected. The Large Crescent Property could not be rented during 1988 due to delays in constructions and the difficulty of finding suitable tenants. Moreover, the real estate market went sour and the property could only be rented for $1,000 per month in 1989.
The developer placed a restriction and did not allow rental operation during the occupancy period to the closing date. The property was left vacant and projected revenue could not be met.
Additional problems were encountered with the Sheppard Property. During 1989, the tenant was involved in drug trafficking. No rental payments were made by the tenant. In addition, the property was severely damaged by activities involving police force. The property was vacant pending criminal proceedings. Later, suitable tenants could not be found leading to extensive vacancy rate.
The closing dates for the Grandville and Wellesley Properties were both extended. The rental operation began in the period of decreased rents resulting in lower than projected amount of rental income.
2. A moratorium on rent increases announced in 1990 imposed rent decreases on rental units of froze rental prices for an unspecified term. The rental prices generally went into decline.
3. The onset of a deep recession and other market forces not only affected both the rental prices and all real estate market values, the Appellant’s earning was also negatively affected. As a successful real estate agent before the recession, he was horrified to see his earnings drop dramatically. This had not only affected the losses of value of the rental properties but resulted in the inability of meeting the intended objective of paying down the mortgages with earnings or profits that would have otherwise been generated from the rental operation.
4. The adverse affects of the above factors were increasing debts as it was not possible to attain positive cash flows. The situation had led to unforeseeable losses and placed the Appellant in a position of severe cash deficit. Upon realizing that the properties were not going to be profitable due to the reasons above and in an attempt to minimize operating losses and improve cash flow, some of the properties were disposed.
With reference to the Federal Court of appeal decision, Tonn et al v. Her Majesty the Queen a similar legislative provisions of the Act [ie. subsections 9(1), 18(l)(a), (h) and 248(1)] each of which outlined a deductibility test is applicable to the Appellant’s situation in this case. The common law test requiring a “reasonable expectation of profit” is also relevant. Linden, J. stated,
...when the circumstances do not admit of any suspicion that a business loss has been made for a personal or non-business motive, the Moldowan test (Moldowan v. R., (77 D.T.C. 5213) [1978] 1 S.C.R 480) should be applied sparingly, and with a latitude favouring the taxpayer, whose business judgment may have been less than competent....
In the application of the above principles to the Appellant’s situation, it was clear that the rental activities were purely commercial, undertaken when the rental market appeared profitable and promising. But as a result of unforeseen economic and other circumstances as previously stated, the venture became uncertain. The properties were purchased to earn rent revenues from arm’s length tenants, and there was no element of personal use or enjoyment involved.
Counsel for the Appellant referred the Court to Tonn v. R., (sub nom. Tonn v. Canada) [1996] 1 C.T.C. 205, 96 D.T.C. 6001 (F.C.A.), and to several cases quoted in Tonn.
Position of the Respondent
The Respondent submitted that the Appellant did not have a reasonable expectation of profit from renting of the Grandville Street Property, the Large Crescent Property, the Sheppard Avenue Property, the Thunder Grove Property and the Wellesley Property in the 1990, 1991 and 1992 taxation years. Counsel stated that the losses were personal or living expenses of the Appellant and that they were not incurred for the purpose of gaining or producing income from a business or property pursuant to paragraph 18(l)(a) of the Income Tax Act (the “Act”), hence the Appellant was properly reassessed in accordance with paragraphs 18(l)(a) and 18(1 )(h) of the Act. In the alternative, counsel stated that the deduction of the disallowed rental expenses is prohibited by section 67 of the Act as they are not reasonable in the circumstances.
Analysis
The issues the Court is asked to consider are whether the Appellant had a reasonable expectation of profit and, if so, whether the expenses claimed are reasonable. All properties at issue were single residential units. The income and expense projections were prepared in writing for the purposes of these appeals. The Appellant was a real estate agent and familiar with residential real property in the vicinity.
At the commencement of the trial, the Appellants appeared to have the mistaken belief that the issue was whether the profit on the sales of the properties was on capital account or income account. They took the position that any profit on the sales of the units was capital. The Minister of National Revenue took the same position, accepting the net sale proceeds as capital gains or capital losses. While it does not affect this judgment, it is interesting to note that the Minister did not take the position that the Appellant was a trader in real estate. Given the downturn in the real estate market, the Appellant may have ultimately benefited had he been classified a trader in real estate.
As I am reluctantly accepting the conclusion of both parties that the Appellant was not a trader in real estate, then why did he buy the properties? The expenses were not personal or living expenses. The Respondent suggests that the Appellant’s purpose in incurring the expenses was other than that normally associated with holding rental properties. Yet the Respondent states that the properties were held as capital assets, rather than for the purpose of resale. There was no element of personal enjoyment nor any suggestion that the activity of the Appellant was a hobby. It was not presented that the purpose was to obtain a tax advantage. I must conclude that the properties were purchased to earn rental income from the rental business.
The Appellant’s contention was that the properties would be carrying themselves in less than four years. While these projections were highly over-optimistic, it is clear from past jurisprudence that the Minister cannot use hindsight to second guess a taxpayer’s business decision. The Appellant could not be expected to have predicted the economic down turn commencing in 1990.
Expenses were made or incurred by the taxpayer for the purpose of gaining or producing income from the properties within the meaning of paragraph 18(1 )(a) of the Act.
This finding leads to the statement on page 212 (D.T.C. 6009) of Tonn (supra). Justice Linden recommended that where the Minister challenges the reasonableness of a taxpayer’s transactions, she should refer to section 67 of the Act and not to the heavy handed “reasonable expectation of profit” approach.
Section 67 states that an income deduction can be made only for reasonable expenses in the circumstances. The Court is required to determine what expenses are reasonable in the present circumstances.
I am not satisfied that the projections of income and expenses submitted were a duplications of the projections prepared prior to each purchase. The properties were obviously under capitalised. In order to expect a profit within a reasonable period of time, being at least within five years from date of purchase, sufficient capital would have to be paid to reduce the mortgage principal and, thus, substantially reduce the interest payments.
I cannot conclude that the interest expense is reasonable, given that the financial structure for the properties during the relevant years required, in most instances, interest payments that were 30% to 60% greater than the income. For the annual interest expense to be considered “reasonable in the circumstances”, surely it alone should not generally exceed the gross annual income. This is particularly true in the present case where the Appellant did not have further capital to reduce the mortgage debt on the properties within the reasonable future. I conclude that, in the present circumstances, interest should not generally exceed the gross rental income in order to be considered a reasonable expense.
I believe that some of the other expenses claimed could more accurately be classified as capital expenses. These expense claims are reduced somewhat arbitrarily in keeping with an effort to comply with section 67 of the Act.
My conclusions are as follows:
1. 42 Large Crescent - the interest claimed is reduced from a total of $4,437.14 to $3,000.00 and “other expenses” from $845.00 to $500.00, to be pro-rated in keeping with the Appellant’s 50% share of ownership. (It is noted that this property was held vacant pending closing of a sale. Under those circumstances, I am allowing the interest and the “other expenses” to exceed the gross rental income for this property.)
2. 1407-1900 Sheppard Avenue - the total interest claimed is reduced from $14,080.85 to $10,500.00 for 1990, and from $13,087.82 in 1991 to $7,175.00, and remains unchanged at $10,773.37 for 1992. The “other expenses” for 1990, 1991 and 1992 are reduced from $5,843.02 to $5,250.00 in 1990, and from $6,845.43 to $3,587.00 in 1991 and remain unchanged at $5,539.00 for 1992. In this manner the “other expenses” do not exceed 50% of the gross rental income. These are to be pro-rated in keeping with the Appellant’s 50% share of ownership.
3. 607-30 Thunder Grove - the total interest claimed is reduced from $14,893.00 to $13,225.00 (so as not to exceed the gross rental income) and the “other expenses” claimed remain unchanged at $6,472.56.
4. 2104-25 Grandville Street - the total occupancy fee is reduced from $24,167.26 to $12,900.00. The interest is reduced from $14,271.07 to $11,700.00 for 1991, and from $14,270.00 to $11,700.00 for 1992, so as not to exceed the gross rental income. The “other expenses” are reduced from $6,646.99 to $5,850.00 for 1991, and from $6,521.00 to $5,850.00 for 1992. The reduction is made to reflect the “other expenses” at an amount not exceeding 50% of the gross rental income.
5. 2205-24 Wellesley Street - this property was owned by the Appellant alone. In 1991, the gross rental income is reflected as $10,350.00 and the total expenses $28,177.87, almost three times greater than the income during the first year of operation. In 1992, the gross rental income was $12,000.00 and total expenses $31,400.45. There was no satisfactory explanation for these extraordinary expenses. With the evidence presented, it is not reasonable to conclude that the Appellant would ever realize a profit from 24 Wellesley Street and, therefore, no losses from this property are deductible from the Appellant’s taxable income. I conclude that the Appellant did not purchase and retain this property for the purpose of earning income from the rental business.
In summation, the losses attributable to Rajesh Monga are as follows:
1.: 42 Large Crescent: 1990: $1,675.00
2.: 1407-1900 Sheppard Avenue: 1990: $2,625.00
1991: $1,793.50
1992: $2,156.19
3.: 607-30 Thunder Grove: 1990: $6,472.56
4.: 2104-25 Grandville Street: 1990 NIL
1991: $5,850.00
1992: $5,850.00
5.: 2205-24 Wellesley Street: 1991 - NIL
1992-NIL]
A more detailed review is contained in Schedule “A”, attached to this judgment.
The appeals are allowed and referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.
Appeal allowed.