Albert Jones

It was April 29, 1993 and Kathy Spratt, a chartered accountant operating as a sole proprietor, had just finished meeting with a new client, Albert Jones. Albert, a 30 year old property appraiser who resided in Grand Falls, Newfoundland, had called Kathy the previous day pleading for assistance with his 1992 personal income tax return. As Kathy reviewed her notes from the meeting and sorted through the supermarket bag full of papers that Albert had left with her, she understood why he had appeared so distraught. She recognized the complexity of Albert's case and the need for a timely response to his many questions.

Background Information

The three-hour session with Albert had generated a substantial amount of information that Kathy needed in order to determine Albert's tax liability. Albert had been employed by Town Appraisers Limited since 1988, ever since he became a licensed appraiser. Since beginning employment, Albert had seen many opportunities for buying properties at good prices. He had


This case was prepared by Professor Pauline Downer of Memorial University of Newfoundland for the Atlantic Entrepreneurial Institute as a basis for classroom discussion, and is not meant to illustrate either effective or ineffective management. Some elements of this case have been disguised.

Copyright 1993, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproductions must acknowledge the copyright. This permission does not include publication.


decided that he would buy some to be used as rental units, and also buy some to renovate and later sell, hopefully at a substantial profit. During the 1992 year, Albert owned and rented six different properties in the town of Grand Falls and surrounding areas. The rental income and expenses of the six properties are included in Exhibit 1. Albert felt that by deducting the rental expenses, he would have a big rental loss and therefore would be able to get a refund of all the taxes that were deducted from his employment income. Exhibit 2 outlines the undepreciated capital cost of each rental property at the end of the prior year.

During the year, Albert also sold two properties that had previously been rented. On January 1, 1992, 60 Birch Road was sold for gross proceeds of $63,000. This had been purchased on August 30, 1991, at a cost of $42,000. (Both these prices included land values). Legal costs on the purchase of the house were $912. During the prior year, capital additions had been made to the property in the amount of $7,323. Closing costs on the sale amounted to $1,131.

The second property sold during the year was 44 Jacksons Lane. This property was purchased on August 1, 1989, at, a cost of $45,275. Legal costs on the purchase were $1,331. The net proceeds received by Albert was $ 78,265 after the lawyer had deducted closing costs of $1,235. The date of sale was May 1, 1992.

Exhibit 3 outlines Albert's prior transactions with respect to capital gains and losses.

Albert also indicated that in 1988 he sold a property to a man by the name of Frank Day. When Albert sold this to Frank, Frank did not have the down payment that his bank required to dose the deal, so Albert had lent Frank the $4,700 shortfall. The loan was documented by the lawyer and was a non-interest bearing note with specified terms of repayment. Unfortunately Frank had never made any payments on the loan and Albert had decided after exhausting all available avenues of collection, that his $4,700 would never be recovered.

Albert's T4 from Town Appraisers Limited for the past year showed the following information:

Gross employment income $ 45,519
Canada Pension Plan premiums Maximum
Unemployment insurance premiums Maximum
Income tax deducted 12,052
Pension adjustment Nil
He had received a T5 from Canada Trustco Mortgage Company which showed interest income of $557.18. He also received a T3 from ManuLife Equity Fund which showed the following information:
Capital gains $144
Capital gains eligible for the exemption 144
Taxable amount of dividends 105
Other income 35
Albert was married to Stephanie and they had no children. Stephanie worked during the year and had a T4 which showed that she earned $2,572 of income.
Albert had paid $535 to another accountant last year for the preparation of the rental statements. He also paid $375 to Richardson Greenshields for administration of his RRSP. Albert received a refund on his tax return last year including $98 of interest income from Revenue Canada when he received his refund cheque in August. Albert also cashed some Canada Savings Bonds and received interest of $ 2,450. No amount of interest had previously been reported as the bonds were purchased and sold in the current year.

Town Appraisers Limited required that Albert use his vehicle for business purposes. He had been reimbursed $3,554 during the year. This amount was not included on Albert's T4. Albert estimated that he drove the car 14,000 kilometres for business, out of the total 28,000 kilometres driven. His vehicle expenses for the year were as follows:

Fuel and oil $3,827
Repairs and maintenance 1,054
Insurance 793
Licensing and registration 111
The undepreciated capital cost of the Class 10 asset at the end of the preceding year was $9,400.
Albert also paid $375 in membership fees to the Canadian Appraisal Institute of Canada. During the year, Albert received $669 in interest from a second mortgage that he held on a property that he sold some years ago.

The Situation

In addition to the background information that Albert had provided, Kathy also reflected on a number of issues arising from Albert's many comments and questions. As she closed her eyes and let her head fall back in the chair, she could still hear Albeit saying...

"I know I'm late asking you to do this, but my friend whose a cracker jack at this sort of stuff, told me that as long as I'm going to get a refund, I don't have to worry about filing my return by April 30th. I don't think that I will have any tax to pay because I have obviously more rental expenses than revenue, and the profit on the sale of the rental properties during the year won't be taxed because I can use my capital gains exemption. I think Stephanie and I will take a trip to Disney World when I get myrefund. As a matter of fact, I think I will book the tickets today, and hopefully, I will have my refund soon.

Another buddy of mine told me that I should start a company and sell the properties to the company, and that way I would pay less tax. He said something about a deduction for small businesses which makes them taxable at a lower rate than individuals. The rental properties should start earning a profit in the not too distant future.

I'm considering branching out and investing in a condominium in Sarasota, Florida. Stephanie and I have decided that we would like to retire there, and I feel that I can purchase the property now, rent it out, and the rental should help me purchase the condominium. I don't expect to earn any profit on the rentals, because I will have a large mortgage on the property and it is doubtful that the rent that I can charge will cover the interest on the mortgage. This should also help me reduce my tax bill each year, as it will increase my rental losses. I'm not even exactly sure how Canada looks upon these situations."

As Kathy opened her eyes they fell on the paper where she had noted the price of the condominium - $150,000 US. She knew this would be a long night!


Exhibit 1

SUMMARY OF RENTAL INCOME AND EXPENSES

60 Birch 44 Jacksons 46 Reids
Road Lane Road
Rental income $3,325 $ 400 $9,444
Rental expenses:
Property tax 251 217 1,315
Repairs 7,565*
Interest 3,493 2,515 14,906
Insurance 200 50 600
Light, heat and water 42 7 2,049
Water tax 160 160 640
Advertising 1,200
44 Reids 60 Maple 78 Pinto
Road Street Street
Rental income $13,275 $5,700 $10,246
Rental expenses:
Property taxes 749 288 270
Repairs 4,325 2,859 2,108
Interest 9,869 4,161 5,483
Insurance 423 285 605
Light, heat and water 1,485
Water tax 480 160 320
Advertising 892
* Included in this amount is $2,500 for repairing the roof. The roof needed to be reshingled to bring it back to its original condition. Included in this amount is also $2,500 for construction of a sun room in the house.
Albert also used his vehicle in performing his duties related to his rental activities. He estimated that he used his vehicle 25% to carry out these duties.
Albert also had a separate telephone line for his tenants to use in order to contact him. The cost of this was $731 for the year.

Source: Company records

Exhibit 2

SCHEDULE OF UNDEPRECIATED CAPITAL COST
AT THE END OF THE PRECEDING YEAR

Class 1 - UCC at end of preceding year $213,317
This class consists of all properties purchased which cost less than $50,000 per property.
Class 1 - 46 Reids Road- UCC at end of preceding year $ 62,000
Class I - 44 Reids Road- UCC at end of preceding year $ 69,395
Notes:
No capital cost allowance has ever been taken on these properties.
The previous accountant had included in the additions to the class both land and building costs for the Birch Road and the Jacksons Lane properties. No adjustment has ever been made to correct the error.

Source: Company records

Exhibit 3

PRIOR YEARS INFORMATION

Investment expenses claimed in prior years:
Carrying charges claimed in prior years $3,989
Rental losses claimed in prior years 41,339
Investment income reported in prior years $ 2,495
Capital Gain Information
Taxable capital pins reported after 1984 and before the current year $ 46,460*
Capital gains exemption claimed from 1984 and before the current year $ 14,199*
* An amounts have been adjusted for the change in inclusion rates
Source: Company records