Date: 20001016

Docket: 1999-3847-IT-I

BETWEEN:

CHEE ANG LOONG,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

(Delivered orally from the bench at Montréal, Quebec, on September 1, 2000 and subsequently revised)

The Honourable P.R. Dussault, J.T.C.C.

[1]            This is an appeal from an assessment for the 1997 taxation year.

[2]            By that assessment, the Minister of National Revenue, (the "Minister") disallowed the deduction of a rental loss in the amount $7,100 and of a terminal loss in the amount of $32,900 relating to a condominium located at 304-1200 Curé-Poirier in Longueuil, Quebec, which was called "Les Tours du Parc".

[3]            The losses were disallowed on the basis that, in 1997, the Appellant had no reasonable expectation of profit from the condominium during that year. At this point, I might add that the Appellant had previously claimed rental losses with respect to the condominium from 1990 to 1996 and that the losses were also disallowed for 1995 and 1996.

[4]            The Appellant, who is a research scientist working for the National Research Council in Boucherville, Quebec, claimed to have always been interested in various investments such as stocks, bonds, mutual funds and real estate.

[5]            In 1990, he was looking for a long-term investment and after having evaluated the potential of other condominiums, he decided to invest in Les Tours du Parc, as he considered the project's potential for appreciation in value to be high. It was located across from a park, near a hospital and close to a Pratt and Whitney plant, and it had many other amenities.

[6]            According to the Appellant, the total price paid was close to $113,000. It was financed through the developer with as security a first hypothec for an amount of approximately $88,000 (see the financial statements accompanying Exhibit R-1). The Appellant also obtained a second hypothec for an amount of approximately $25,000 and paid $500 in cash (I note that these figures differ slightly from those set out in paragraph 3(b) of the Reply to the Notice of Appeal, but this is not material to the issue raised).

[7]            In his testimony, the Appellant stated more than once that he was expecting a conservative 5% a year appreciation in value over a ten- to fifteen-year period together with an increase in rental income.

[8]            The arrangement with the developer was that the condominium would be managed by the developer of the project or a related entity for the period from 1990 to 1993 inclusive. According to the Appellant, the management arrangement included a guaranteed rental income of $8,400 a year for 1991, 1992 and 1993. For 1990, the guaranteed amount was $2,100 for three months (Exhibit A-10 is a closing statement by Les Tours du Parc showing those figures as "rent revenue"). The Appellant said that he had received no income directly during those years and that he had relied on the financial statements provided by the management company to complete his income tax return.

[9]            The Appellant filed in evidence a lease signed by Placements Tours du Parc with a Mr. and Mrs. Plourde for a period of 24 months from July 1 1991 to June 30, 1993 (Exhibit A-2). In it, the rent for July 1991 is said to be free. The rent from August 1991 to June 1992 is set at $735.00 a month and the rent from July 1992 to June 1993 is set at $772.00 a month. The total amount of the lease is $17,349 for the 24-month period.

[10]In his testimony, the Appellant said that he took over the management of his condominium in 1994 and that he was able to rent it for a 24-month period from July 1, 1994 to July 1, 1996 at $772.00 per month. Despite numerous attempts and newspaper ads, the Appellant could not rent it thereafter and he finally disposed of it in 1997, the year in issue. In fact, the transaction that occurred in 1997 was more an exchange for a condominium of a different nature located on Lake Memphremagog, which, the Appellant said, appeared more profitable.

[11]The Appellant said that in 1994, he also paid the debt in the amount of some $24,000 secured by the second hypothec.

[12]In cross-examination, the Appellant's tax returns for the years 1992 to 1997 were filed in evidence (Exhibits R-1 to R-6).

[13]For 1992, the rental income of $8,400 was reduced to $3,885 after taxes, condominium fees, administration fees and various expenses but before the payment of interest on the first hypothec in the amount of $8,686, a special fee for financial services and guarantees in the amount of $6,549 and interest on personal loans in the amount of $2,098. The loss was $13,448.[1] It is obvious that the guaranteed rent of $8,400 a year did not even cover the interest on the first hypothec.

[14]For 1993, the rental income of $8,400 was likewise reduced to $3,820 after taxes and the various fees. At page 2 of the financial statements filed with the return, it can be seen that the interest paid on the first hypothec was $8,587 and that the fee for financial services and guarantees was in the amount of $6,281. The interest on personal loans was indicated to be $4,382 for a total of $19,250 in interest and fees, which brought the loss to $15,430.[2] Here again, the guaranteed income of $8,400 was not even sufficient to cover the interest on the first hypothecary loan.

[15]I refer to these figures because, in cross-examination, the Appellant admitted that he was aware of the developer's projections, that he had seen an English version of the document filed in evidence by the Respondent as Exhibit R-7, and that he knew about the potential tax losses. The document in question contains detailed calculations of losses before secondary financing, interest payable on a line of credit, the total tax losses generated and the tax savings from 1990 (3 months) to 1993 inclusive. The tax savings, the interest payable on a line of credit and the $500.00 cash paid at the time of the offer are then taken into consideration to establish the positive cash flow for the period. In fact, the schedules of cash flow projections found in the promoter's documents are based on a maximization of losses for tax purposes and on 100% financing. I will simply comment here that the document is anything but a well-defined plan to make a profit from rentals.

[16]What is well defined is the utilization of the losses generated for tax purposes. In this context, it is somewhat difficult to refer to the "reasonable expectation of profit" criteria in any serious manner. The expressions expectation and reasonable expectation can be used here only in relation to the tax losses generated, their utilization to reduce income from other sources, the tax savings and the projected cash flow. There is nothing even remotely akin to an expectation of profit, in the commercial sense, from rentals. Despite that, the Appellant was able to deduct the losses claimed in all the years from 1990 to 1994.

[17]I now come to 1994, and I refer to Exhibit R-3. During that year, the Appellant's gross rental income amounted to $7,720. Taking into account the payment of the second hypothecary loan, the claim for interest has been reduced to $6,192.89. However, property taxes of $1,798.60 and various fixed fees for a total of $2,406.69 ($1,677.69 + $494.00 + $235.00) bring the loss to $2,678.18 for that year.

[18]For 1995, Exhibit R-4 shows gross rental income of $7,720, interest on the hypothecary loan of $6,319.25, property taxes of $1,809.53 and various fees for a total of $2,054.62, which results in a loss of $2,463.40.

[19]I might add here that for 1994 and 1995, gross rental income amounted to approximately 75% of the fixed costs.

[20]In 1996, the Appellant's condominium was rented for only the first six months of the year. Exhibit R-5 indicates that gross rental income was $3,860. Interests amounted to $5,825.95, property taxes to $1,808.91 and fixed fees to $1,813.24. Other expenses, including maintenance and repairs and advertising, were claimed for a total of $1,371.99. If we extrapolate from this, by doubling the rent received, to determine what the situation would have been had the condominium been rented the entire year, we are still faced with the bare fact that rental income would have been only 82% of the fixed costs, not to mention the other costs such as maintenance and repairs which should be seen as simply normal during the seventh year.

[21]The 1997 taxation year is the only one in issue. Exhibit R-6 shows no income, as the condominium was not rented. The Appellant explained that it was disposed of during that year. Approximately half the expenses are claimed as deductions. Interest is claimed in the amount of $2,088.00, property taxes in the amount of $780.57 and management and administration fees in the amount of $847.20. Maintenance, repairs and miscellaneous other current expenses amount to $549.59. Finally, an amount of $2,835.00 is claimed as legal, accounting and other professional fees for a total rental loss for the year of $7,100.36. The Appellant explained that the amount of $2,835.00 was for expenses in connection with the sale, or rather the exchange of his condominium for another one located on Lake Memphremagog, which leads to the question whether these expenses were properly claimed as current expenses. However, these particular expenses were not challenged on that basis and I will refrain from commenting any further on this point.

[22]In his testimony, the Appellant stressed the facts that he had paid off the second hypothec in 1994 and that by 1997 he had considerably reduced (by some 30%) the debt secured by the first hypothec. He referred to adverse market conditions in 1996 and 1997 and to the efforts made to secure a tenant, especially by advertising extensively in newspapers.

[23]The Appellant also presented a document entitled "Analysis of Profitability of Investment of Condo at 1200 Curé-Poirier (304B) in 1997" (Exhibit A-5). In this document, the rent is set at $772.00 a month for a total of $9,264 for the year. Interest on the hypothec is set at $5,010, property taxes at $1,808, condo fees at $1,692 and other expenses (advertisements and minor maintenance) at $500.00 for a projected profit of $254.00.

[24]This document warrants a few comments. First, the hypothetical rent at $772.00 a month is obviously based on the rent set in the lease entered into for the period of July 1, 1994 to July 1, 1996 (this should actually read June 30). However, in 1996, the reported rent was $3,860 for six months, or an average of $643.00, not $772.00, a month. In 1995, the reported rent was $7,720 for 12 months, thus once again an average of $643.00 a month, not $772.00.

[25]For 1994, the reported gross rent is also $7,720. I find it somewhat strange that the reported rent does not correspond to the rent stated in the leases. Based on the actual figures and the fact that the various fixed fees have always exceeded $1,700 a year, there certainly would not be much left by way of a profit. In any case, the document in question was prepared after the fact and, in my view, definitely does not constitute a realistic plan for profitability.

[26]Another document, a three-month lease for the new condominium on Lake Memphremagog was also filed in evidence (Exhibit A-8), as proof that the Appellant's objective was profitability. The lease for three months is for $1,000 per month. However, no other details were given to demonstrate profitability.

[27]In his argument, the Appellant claimed that he had made a long-term investment with a view to an appreciation in value over time and a possible increase in the rent. According to him, this was merely a business decision involving no personal element. He says that, in 1997 (the eighth year of ownership), he still had a reasonable expectation of profit that was thwarted only because of adverse market conditions which made it impossible for him to rent the condominium after June 1996. The Appellant said that he might have made an error in judgment but that it was his error and, from what I understand, that he should not be penalized for it. The Appellant is relying on Tonn v. The Queen, 96 DTC 6001, in support of the proposition that taxpayers' business decisions should not be second-guessed after the fact. He is also relying on Saunders v. R., 1998 CarswellNat 156, also reported at [1998] 2 C.T.C. 3196, a case whose circumstances are similar.

[28]The Respondent's position is that the Appellant had no reasonable expectation of profit, that he was interested in making a long-term investment so as to benefit from the tax deductions with a view to realizing a capital gain later. According to the Respondent's representative, until 1994, the Appellant was simply following the developer's plan and the losses claimed were consistent with the developer's projections and figures.

[29]Even from 1994 on, the Appellant could never have realized a profit from renting the condominium because of the scale of the interest payments, despite the fact that he undertook to pay off the loan secured by the second hypothec. Taking into consideration the facts that the Appellant had no particular training or experience in real estate, that he had let others manage the property until 1994 and that losses had been claimed year after year from the very beginning, the Respondent's representative concludes that the Appellant had no reasonable expectation of profit in 1997 and that the losses claimed, namely, the rental loss and the terminal loss, should therefore be disallowed in their entirety.

[30]The Respondent's representative is relying more specifically on Moldowan v. The Queen, [1978] 1 S.C.R. 480; Landry v. The Queen, 94 DTC 6624; Tonn v. The Queen, 96 DTC 6001; Mastri v. Canada, [1998] 1 F.C. 66; Mohammad v. Canada, [1998] 1 F.C. 165; Stewart v. Canada, [2000] F.C.J. No. 238; and, finally, Audet v. The Queen, 2000 DTC 1648. I will just mention here that Audet has been appealed to the Federal Court of Appeal.

[31]The Respondent's representative also argues, if my understanding is correct, that a terminal loss could not be claimed in 1997 because the Appellant owned another building of the same class during the year, namely the condominium on Lake Memphremagog acquired through the exchange. This point of law is not raised in the pleadings and I do not think that it can have any application in the present case because two rental buildings worth $50,000 or more belong to separate classes: (see subsection 1101 (1ac) of the Income Tax Regulations).

[32]As to the question of reasonable expectation of profit, I will start by referring to a very recent Federal Court of Appeal decision in Stewart v. Canada, [2000] F.C.J. No. 238. In that decision, the Federal Court of Appeal made it quite clear that the reasonable expectation of profit test, derived from the well-known Supreme Court decision in Moldowan v. The Queen, has not been altered by any subsequent Supreme Court decision and that its application is not restricted to situations involving an element of personal use.

[33]I think that a brief reference to what Dickson J. said in Moldowan would be useful here. At pages 485-86 of the decision, he stated:

                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. 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.

[34]In the present case, the Appellant claimed consecutive losses for a period of eight years. The losses were quite substantial in the first four years when compared to his rental income, which was not necessarily generated by the condominium but was guaranteed under the arrangement with the developer.

[35]From 1994 on, the losses were smaller because of the reduction of the interest expense due to payment of the debt secured by the second hypothec. However, the annual rental income was never high enough to cover the fixed costs. This was true for 1994 and 1995 and also for 1996 and 1997. It would be true even had a full year's rent, based on the gross rental income reported in 1995 or for six months in 1996, been received in 1996 and 1997. I am obviously ignoring the unfavourable market conditions that, according to the Appellant, prevailed during those two years. My conclusion here is that the losses were not incurred because of unforeseen or unfavourable market conditions. It was the structure of the venture itself that caused them.

[36]This brings me automatically to another factor mentioned by Dickson J.: "the capability of the venture as capitalized to show a profit after charging capital cost allowance." I have already commented on the projection of losses made by the developer and the Appellant's reliance on someone else to finance the acquisition of his condominium with a bare $500.00 cash. It is obvious to me, as I said earlier, that since the guaranteed rent of $8,400 could not initially cover even the interest paid on the first hypothec, not to mention the other fixed costs, there could hardly have been a reasonable expectation of profit at that point in time. But these were the first few years and I will not comment further.

[37]What is more troubling though is that, even after the repayment of the debt secured by the second hypothec, the fixed costs could not be covered by the rental income. Property taxes and condominium and related fixed fees should come as no surprise to someone buying a condominium and should definitely be taken into account in any serious plan to ensure profitability.

[38]After six or seven years, maintenance and repairs should also be taken into account. The fact that the fixed costs could never be covered during eight years in the present case, even if one assumes normal market conditions, certainly raises serious doubts about the existence of a well-defined plan, or for that matter of any plan, to ensure profitability of the condominium as a rental property.

[39]What transpires from the evidence is that the objective of the whole initial financial structure seems not to have been to derive a profit from the rental of the property but, in the short term, to maximize losses to ensure a positive cash flow and, in the long term, to receive the benefit of a capital appreciation giving rise eventually to a capital gain.

[40]I will not comment on the question of capital cost allowance because, as everyone knows, it cannot be deducted if the effect is to increase a loss. However, I have to wonder in what year the Appellant would have been able to show a profit from the venture if he had kept the condominium and capital cost allowance had eventually been taken into account.

[41]As to the Appellant's training and experience in real estate ventures, the simple conclusion is that he had none. Which brings me to "the intended course of action." As I have already said, the Appellant's initial course of action essentially followed the plan laid out by the promoter. He thus claimed substantial losses and was able to realize significant tax savings from 1990 to 1993 inclusive.

[42]In 1994, there was certainly a step in the right direction. By paying the debt secured by the second hypothec, the Appellant reduced the interest expense and thus a substantial component of the fixed costs. However, this was not even enough in the fifth year from purchase to cover those costs. Far from it: in the next year, 1995, he did not do much better even though the condominium was rented for the full year. The last two years were even worse, as we know. The situation just worsened due to market conditions.

[43]In this respect, I must say that I do not accept the Appellant's evidence that he could have earned a gross rental income of over $9,000 during 1997 but for the unfavourable market conditions. This figure is based on the rent fixed in the two-year lease from July 1994 to July 1996. However, as we have seen, no such rental income covering the whole year of 1995 was ever declared. In 1995, the Appellant declared a rental income of $7,720, not $9,264.

[44]My review and analysis of the evidence as a whole, and of the Appellant's testimony in particular, lead me to conclude that the Appellant never had a real and objective expectation of profit from the rental of his condominium and that he did not have a realistic plan to ensure its profitability. This was even more true in 1997, the year in issue, considering that the condominium was bought in 1990.

[45]What the evidence reveals is that the Appellant was more concerned over the years with tax savings in the short term and with a potential capital gain in the long term.

[46]A reasonable expectation of a capital gain is not the equivalent of a reasonable expectation of profit from a property. Indeed, subsection 9(3) of the Income Tax Act states the following:

                In this Act, "income from a property" does not include any capital gain from the disposition of that property and "loss from a property" does not include any capital loss from the disposition of that property.

[47]Subsection 9(1) states the basic principle that income for a taxation year from a business or property is the taxpayer's profit from that business or property for that year. In Moldowan, supra, Dickson J. stated at page 485 that:

                . . . in order to have a "source of income" the taxpayer must have a profit or a reasonable expectation of profit.

[48]This principle applied to a rental property simply means that a taxpayer must have a profit or a reasonable expectation of profit from the rental thereof and from the rental alone (see Foldy and Jarian v. M.N.R., 91 DTC 361 at 363).

[49]The burden of proof with respect to such an expectation of profit rests with the taxpayer. My conclusion in the present case is that the Appellant has failed to convince me on a balance of probabilities that he had such an expectation.

[50]Finally, I will make a few comments on the decision in Saunders v. The Queen, referred to by the Appellant. First, in that case, the years in issue were the third, fourth and fifth years from the date of purchase. Second, the taxpayers clearly demonstrated that they had a realistic plan to attain profitability, even though the purchase of the condominium was financed at 100%, by showing, inter alia, the possibility of increasing the rent, which was in fact steadily increased over time. Third, they did in fact make a profit in the eighth year according to their plan.

[51]I think these factors are sufficient to distinguish that case from the situation in the present appeal.

[52]For the above reasons, the appeal from the assessment for the 1997 taxation year is dismissed.

Signed at Ottawa, Canada, this 16th day of October 2000.

"P.R. Dussault"

J.T.C.C.

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