If you have a loss from a business or a rental property in a taxation year, you can use the loss to offset other sources of income in the year.
For example, if I have $50,000 of employment income but also carry on a side business with a loss of $30,000, my income for tax purposes will be $20,000.
The “catch” is that the loss must be from a “source”.
If the loss is apparently from a business or property, the issue is not always straightforward because of the source issue.
At one time, the CRA and the courts took the position that you could have a loss from a business or property source only if you had a reasonable expectation of profit (“REOP”). If you did not have an REOP you did not have a source and your loss could not be used for tax purposes.
Fortunately, the Supreme Court of Canada clarified the source rules in the landmark Stewart case, back in 2002.
According to the Supreme Court, the source rules are as follows:
First, if your activity is “clearly commercial”, basically meaning that it is a business or investment activity with no personal element, then any loss from the activity will be recognized for income tax purposes.
However, if your activity has some personal element to it, the source issue becomes more complicated. In such case, the courts must look at the following factors to determine whether you have a source and therefore whether your loss will be recognized for tax purposes:
“(1) the profit and loss experience in past years; (2) the taxpayer’s training; (3) the taxpayer’s intended course of action; and (4) the capability of the venture to show a profit…it is not necessary for the purposes of this appeal to expand on this list of factors. As such, we decline to do so; however, we would…caution that this list is not intended to be exhaustive, and that the factors will differ with the nature and extent of the undertaking. We would also emphasize that although the reasonable expectation of profit is a factor to be considered at this stage, it is not the only factor, nor is it conclusive. The overall assessment to be made is whether or not the taxpayer is carrying on the activity in a commercial manner.”
In other words, where your activity has a personal element and a commercial element, it will be a question of fact as to whether it is a “source” such that a loss from the activity will be recognized for income tax purposes.