Edmundo Sanchez v. Her Majesty the Queen, [1997] 1 CTC 2572 (Informal Procedure)

McArthur J.T.C.C.: — The appeals of Edmundo Sanchez were heard in Toronto under the Informal Procedures of this Court on common evidence with the appeals of Rajesh Monga and Neera Monga.

The issue is the deductibility of rental losses incurred by Mr. Sanchez in the 1990 and 1992 taxation years. The amounts of the losses claimed by him were $12,145.04 in 1990 and $14,531.00 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. During the relevant period, the Appellant lived with Maritza Ratti, a real estate agent. In 1992, the Appellant ceased his work with IBM and became a real estate agent.

The Appellant reported income and rental losses for properties as fol-

lows:

The registered deeds, in many instances, did not accurately reflect the true ownerships and purchase prices of the properties as stated by the Appellant. The ownerships, as reflected in the Appellant’s 1990 and 1992 Federal Individual Income Tax Returns, are as follows:

-42 Large Crescent: Edmundo Sanchez 25 per cent, Maritza Ratti 25 per cent, Rajesh Monga 50 per cent.

-37 Tineta Crescent: Edmundo Sanchez 50 per cent, Maritza Ratti 50 per cent.

-1411-30 Thunder Grove: Edmundo Sanchez 75 per cent, Maritza Ratti 25 per cent.

-4 Knightsbridge: Edmundo Sanchez 25 per cent, Maritza Ratti 25 per cent, Rajesh Monga 50 per cent.

The Appellant presented the Court with rental projections prepared after the purchases of the properties which projected profits at least within a few years of each purchase. The evidence indicates that projections of income and expenses were prepared informally prior to each purchase and produced in writing years later for the purpose of these appeals. The projections were highly optimistic when scrutnized with the actual income and expenses.

Position of the Appellant

Written submissions were filed on behalf of the Appellant that read inpart as follows:

The Appellant recognized at the time that real estate was a good long-tenr investment and acted in good faith and as a prudent entrepreneur when he invested in the aforementioned properties. They were purchased with th*- stated intention to be used as a source of property income.

Although he was not that familiar with rental operations, his partners, Monga and Ratti were both real estate agents. From their profession, they have access to specific rental and real estate information similar to the acquired properties. With the aid of the MLS current and past data along with their work experience, they anticipated obtaining rental income of $1,200 throughout 1987 and 1988 from the Large Crescent Property, and further anticipated that yearly revenues would increase by approximately 5 per cent in succeeding years. ‘The mortgage principal would be paid down at an estimated rate of 5 per cent initially with sources of funds from each investor’s earnings and in later years from the net profits.

Similarly, the Appellant anticipated obtaining rental income from the Thunder Grove Property of $1,200 per month initially, and further anticipated that yearly revenues would increase by approximately 5 per cent in succeeding years. With the intention of certain repayments of the borrowed money, Mr. Sanchez expected to begin earning profit starting in 1989. At this point, the mortgage would be reduced further by profits generated in addition to funds from other sources.

The Tineta Property would generate rental income of $1,150 per month for the main floor, and additional $750 per month for the basement apartment. Based on similar projections above, it was expected to realize profit as early as 1989.

The Knightsbridge Way Property was estimated to be rented for $1,200 monthly. Based on the same forecast as other properties, the profitable position could be attained in 1993.

On the basis of income and expense projections, the overall rental operations would be in a profitable position after 1989. As such, this venture 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 construction 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.

Similarly, the Thunder Grove Property’s rent decreased from $1,150 per month during 1988 to $1,000 per month in 1989. The Appellant ex- perienced first hand of a landlord’s nightmare involving in situations which tenants stopped paying rents and decided to vacate the premises without any payments. There were also extensive damages done to the property.

Additional problems were encountered with the Tineta Property. Suitable tenants could not be found and disputes between the main floor and basement apartment tenants led to extensive vacancy rate.

2. A moratorium on rent increases announced in 1990 imposed rent decreases on rental units or 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 livelihoods of two of the partners of the venture were also negatively affected. Both partners who were real estate agents saw their earnings drop dramatically. This resulted in the inability of meeting their intended objectives of paying down the mortgages.

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.

5. The downturn in the economy prompted IBM to restructure. As a result, in 1992, the Appellant lost his job as a system engineer. Later on that year, the common law relationship with Maritza Ratti ended, forcing the Appellant out of their shared residence into the Knightsbridge Way Property which was converted to a principal residence.

Counsel for the Appellant referred the Court to Tonn v. R. [1996] 1 C.T.C. 205, 96 D.T.C. 6001 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 the Large Crescent Property, the Tineta Crescent Property and the Thunder Grove Property in the 1990 taxation year and the Knightsbridge Way Property in the 1992 taxation year. Counsel stated that the losses were personal or living expenses of the Appellant, and that the disallowed rental expenses were not incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(l)(a) of the Act. In the alternative, he 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

With partners, the Appellant purchased three single family units in the Toronto area in 1987 or 1988 during a rising market. All three properties were sold at a profit in 1990 or 1991. All three were rented prior to sale and incurred substantial rental losses. He incurred further losses from the purchase of a townhouse in 1991. It was converted to his principal place of residence in January 1993. It is all these losses he seeks to deduct.

It appears that at the outset of trial, the Appellants had the mistaken belief that the primary question was whether the profit on the sales was on capital account or income account. They took the position that it was on capital account. The Minister of National Revenue took the same position, accepting the net sales 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. The Appellant may have ultimately benefited had he been a trader in real estate.

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.

In 1990, 42 Large Crescent was vacant for four months pending a sale which resulted in a capital gain. The Appellant’s 25 per cent share of the gross rental income was $37.50, and his losses $1,283.04.

In 1990, the Appellant’s 50 per cent share of the gross rental income from 37 Tineta was $2,850.00, and his losses $4,076.00.

In 1990, the Appellant’s 75 per cent share of the gross rental income from 1411-30 Thunder Grove was $6,600.00, and his losses $6,786.00.

In 1992, the Appellant reported gross rental income from Knightsbridge of $4,200.00 and total expenses of $18,731.00 for a net rental loss of $14,531.00.

I will begin by dealing with the first three properties. 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 three years. While these projections were proven 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 downturn 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 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 duplication of the projections prepared prior to each purchase. The properties were obviously undercapitalised.

In order to expect a profit within a reasonable period of time, being at least within five years from the 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 on the properties during the relevant years required, in most instances, interest payments that were 30 per cent to 60 per cent 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 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 the “other expenses” from $845.00 to $500.00, to be pro-rated in keeping with the Appellant’s 25 per cent share of ownership. (It is noted that this property was held vacant pending closing of a sale. Under the circumstances, I am allowing the interest and the “other expenses” to exceed the gross rental income for this property.)

2. 37 Tineta Crescent - the interest claimed is reduced from $9,512.00 to $5,700.00 (so as not to exceed the gross rental income) and the “other expenses” reduced from $4,340.00 to $2,850.00 (so as not to exceed 50 per cent of the gross rental income). These are to be pro-rated in keeping with the Appellant’s 50 per cent share of ownership.

3. 1411-30 Thunder Grove - the interest claimed is reduced from $10,752.00 to $8,800.00 (so as not to exceed the gross rental income) and the “other expenses” reduced from $7,096.00 to $4,400.00 (so as not to exceed 50 per cent of the gross rental income). These are to be pro-rated in keeping with the Appellant’s 75 per cent share of ownership.

With respect to the Knightsbridge property, I find that it is not reasonable to accept that the Appellant purchased this property for the purposes of gaining rental income. It was bought after his experience with losses in the three other properties dealt with. The interest alone was more than 2.5 times greater than the rental income. The income in 1992 was $4,200.00 and the expenses $18,731.00. After approximately one year he converted it to his own residence. I agree with the Respondent that the losses for this property were personal or living expenses, hence the Appellant was properly assessed.

Therefore, the losses attributable to Mr. Sanchez for 1990 for the three properties are

1. 42 Large Crescent: $ 837.50

2. 37 Tineta Crescent: $1,425.00

3. 1411-30 Thunder Grove: $3,300.00

The losses for the Knightsbridge property, that can be deducted from income, are 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.