If you own a rental property , you likely bought it because of the monthly rental income the unit would provide, with the hope of ultimately being able to sell it for a profit in the future. Indeed, some landlords are okay with ongoing rental losses (as long as they are not too large) because they’re counting on the capital appreciation over the long term to more than make up for any temporary negative cash flows.
But it’s important to keep in mind that for those rental losses to be tax deductible , the property must be rented out for the purpose of earning income. A recent tax case, decided last month, involved a taxpayer who wrote off rental losses as well as large legal expenses for the 2020 and 2021 tax years in connection with a property he owned in the Ottawa region that he rented to his parents for more than two decades. The Canada Revenue Agency disallowed his rental losses and deduction for legal fees, arguing that the taxpayer did not have a source of income and was therefore not entitled to claim these deductions.
The taxpayer owned three rental properties, one of which he purchased as an investment property in 1996 with the “sole intention” to generate income. His parents were the first tenants and they signed a five-year lease back in October 1996 agreeing to pay rent of $900 per month, plus utilities. When the lease expired in September 2001, a new one-year lease was signed on the same terms. After that lease expired no subsequent lease was signed but his parents continued to pay $900 of rent each month.
In 2016 the taxpayer’s father died and his mother continued to live in the property. Since his mother’s monthly income was just enough to cover her personal living expenses such as groceries, telephone and internet, the taxpayer did not charge her any rent from 2016 until she moved into a care facility in February 2020.
At that time, the taxpayer wanted to rent the property to new tenants and began the process of removing his parents’ furniture and personal belongings, and planned to clean and paint the entire property. But then, a conflict arose between the taxpayer and some of his siblings who took the position that the property formed part of their mother’s estate. They argued that the property was actually purchased by their parents in 1996, but was registered in the taxpayer’s name because his parents didn’t qualify for a mortgage.
As a result of this conflict, a “certificate of pending litigation” was registered on title which prevented the taxpayer from renting out the property. As a result, it remained vacant until 2023.
The taxpayer spent significant legal fees to defend his ownership and title to the property. The matter between him and his siblings was ultimately settled in November 2022 and the minutes of settlement support the conclusion that while the taxpayer held exclusive legal title to the property in 2020 and 2021, the property was held in trust for his parents. In April 2023, the Ontario Superior Court of Justice ordered that it be sold and the net proceeds of sale be set aside for the benefit of his mother.
The question before the Tax Court was whether the taxpayer could deduct the rental losses and legal fees for the 2020 and 2021 taxation years. At trial, the taxpayer testified that the rent he charged his parents in 1996 “reflected market rates for similar properties at that time,” although he acknowledged that it was “just enough to cover the mortgage payments and realty taxes.” He further accepted that he was not actually making a profit and had reported rental losses over the years. He never increased the rent from 1996 to 2016, and when his father passed away, he did not collect any rent from his mother, “on compassionate grounds.”
The judge referred to the 2002 seminal Supreme Court of Canada case, which struck down the old “reasonable expectation of profit test” and found that where there is no personal element to a particular activity and the activity was carried out in a sufficiently commercial fashion, then a taxpayer should be permitted to deduct his or her expenses relating to that activity, even if it creates a loss.
In the present case, however, the judge was not convinced that the taxpayer truly intended to realize a profit from the property. First, his tenants, being his parents, were not at arm’s length from the taxpayer. Second, the rent was not increased from 1996 to 2016, a period of more than 20 years, nor was rent collected or charged to his mother for another four years after his father’s death. As a result, the judge inferred that the “real arrangement” between the taxpayer and his parents was simply to ensure that both the mortgage payments and property taxes were paid rather than to make a profit from renting out the property.
The judge therefore concluded that the taxpayer did not have a source of income from a business or property during the taxation years under review and consequently he was not entitled to claim the rental losses.
The taxpayer also incurred nearly $120,000 in legal fees following the registration of the certificate of pending litigation, which he attempted to deduct on his 2020 and 2021 tax returns. The judge turned to the Income Tax Act , which provides that a taxpayer may deduct expenses that are incurred to earn profit, subject to various limitations. One of those limitations is that no deduction shall be made “except to the extent that it was made or incurred for the purpose of gaining or producing income from the business or property.” Since the judge already determined that there was no source of income, the legal expenses were not deductible.
Here’s what happened when a taxpayer claimed a swimming pool as a medical expense CRA demands arrears interest on donation tax shelter bought by ex-husbandThe judge went on to note that even if there was a source of income, the Tax Act prohibits the deduction of “personal or living expenses.” Since the taxpayer was essentially holding the property in trust for his mother, his legal expenses related to a family dispute “akin to estate litigation,” were not connected to a source of income, and were therefore not tax deductible as they were personal expenses.
Jamie Golombek, FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. [email protected] .
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