Taxpayer loses case to deduct costs and losses while renting to parents

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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.”

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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.

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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.

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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.

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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.

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The 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.

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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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