Rental activities are generally treated as passive activities under IRC §469, limiting the ability of taxpayers to offset losses from such activities against other income. However, a special rule applies to individuals who can meet the qualifications to be a real estate professional under IRC §469(c)(7). The taxpayers in the case of Sezonov v. Commissioner, TC Memo 2022-40,[1] attempted unsuccessfully to argue they qualified for this status.

Real Estate Professional Requirements

A person qualifies as a real estate professional if both of the following requirements are met for the tax year:

More than one-half of the personal services performed in trades or businesses by the person during such taxable year are performed in real property trades or businesses in which the person materially participates, and
This person performs more than 750 hours of services during the taxable year in real property trades or businesses in which the person materially participates.[2]

If a married couple is filing a joint return, at least one spouse must satisfy both requirements without reference to the services performed by the other spouse.[3]

Real property trades or businesses for this purpose are trades or businesses that are in the real property businesses of:

Development,
Redevelopment,
Construction,
Reconstruction,
Acquisition,
Conversion,
Rental,
Operation,
Management,
Leasing, or
Brokerage.[4]

If these requirements are met the rental activities are not automatically considered to be passive activities. The taxpayer still has the burden of showing that the rental is not otherwise a passive activity under the general rules of IRC §469(c). But the taxpayer now has the possibility of showing that he or she materially participated in the rental activity or activities which will cause them not to be treated as a passive activity.[5]

The Facts in This Case

The Court begins by noting Mr. Sezonov’s other activities during the years in question:

During the years at issue, Mr. Sezonov was the only member of Design Build Service, LLC (DBS), a single-member LLC through which he operated a wholesale HVAC business. Mr. Sezonov operated the HVAC business full time and with no employees throughout 2013 and 2014.[6]

The Court also gave the details of the couple’s rentals:

In 2013 DBS purchased two properties in Florida: a property on Reybell Lane in Palm Coast, Florida (Reybell property), and a property on Marina Bay Drive in Flagler Beach, Florida (Marina Bay property) (collectively, Florida rental properties). DBS purchased the Reybell property on April 24, 2013, and it purchased the Marina Bay property on November 21, 2013. The Sezonovs through DBS rented out both properties during 2013 and 2014 while maintaining their primary residence in Ohio.

After DBS purchased the Reybell property, the Sezonovs leased the property to its previous owners until June 14, 2013. When those tenants vacated the property, the Sezonovs cleaned and furnished the property to prepare it for future rentals. Once this work was completed, the Sezonovs leased the Reybell property to a tenant for a one-year term beginning September or October 2013.

After DBS purchased the Marina Bay property, the Sezonovs hired contractors to make improvements and repairs to the property so that it could be leased as a short-term vacation rental. Additionally, shortly after purchasing the property, DBS filed a lawsuit against the Marina Bay property’s condominium association to secure the rights to a boat slip that should have been conveyed with the property.

The Marina Bay property was first made available to rent in December 2013, and it was rented for the first time in January 2014. Most of the Marina Bay property leases were for one-month terms.

Mrs. Sezonov advertised the Florida rental properties and communicated with renters and prospective renters via email. In between rentals, Mrs. Sezonov would clean and prepare the Marina Bay [*3] property for its next renter or hire a cleaner to do so on her behalf. Mr. Sezonov assisted in responding to emails, as well as performing maintenance and repairs for the properties, but Mrs. Sezonov was responsible for most of the day-to-day management.[7]

Remember that it is the responsibility of the taxpayer to show that he or she meets the requirements to claim a tax benefit under the law. In this case that benefit would be being classified as a real estate professional. The court looked at the nature of the records the taxpayers had to back up that assertion.

The Sezonovs did not maintain contemporaneous records of the hours that they worked on their Florida rental properties. However, in 2019 and 2020, while this case was pending, Mrs. Sezonov created time logs estimating the time that she and Mr. Sezonov had worked on the Florida rental properties in 2013 and 2014. The time estimates shown on the logs are summarized below:

The taxpayers claimed the entire loss from the rentals for each year as fully deductible on their tax returns. The Court also noted that the taxpayers did not make an election to aggregate all of their rental activities under §469(c)(7)(A).

Taxpayers Failed to Qualify as Real Estate Professionals

Most readers have probably figured out from the original discussion of what is necessary to be treated as real estate professional that the taxpayers were not going to prevail in this case. And that is what happened.

While the taxpayers record keeping was not the best, or even adequate, it turns out that doesn’t really matter. As the court notes, even if we accept their calculation of hours as correct they simply don’t qualify as real estate professionals.

Even if we were to accept the time logs as credible and accurate in all respects, they are insufficient to prove that either of the Sezonovs qualifies as a real estate professional within the meaning of section 469©(7). …

Both Mr. and Mrs. Sezonov’s estimated hours fall well short of the 750 hours that are required to qualify them as real estate professionals in each of the years at issue. For 2013 the Sezonovs estimate that Mrs. Sezonov spent less than 500 combined hours working on both Florida rental properties (including time spent travelling to and from the rental properties from her home in Ohio). For 2014 they estimate that Mrs. Sezenov spent less than 100 hours working on the Florida rental properties. Likewise, they estimate that Mr. Sezonov spent less than 500 hours working on the Florida rental properties in 2013 and less than 50 hours in 2014. Additionally, Mr. Sezonov fails to satisfy the requirement of section 469(c)(7)(B)(i) because he did not spend more time working in the real estate rental business than in his HVAC business in either year.[9]

Even if the number of hours they had computed had met the bare minimum hour requirements to be real estate professionals, the Tax Court also pointed out that their records were simply not adequate to support the claimed hours.

The Sezonovs did not keep any contemporaneous records of the hours they worked, but Mrs. Sezonov used various documents, such as rental agreements and emails related to the Florida rental properties, to assist her in estimating the time. The time logs she prepared are the only documents in the record that describe the personal services the Sezonovs performed and estimate the time spent performing those services. The time logs, however, are often unclear about who worked which hours, and the time estimates appear excessive in several respects.[10]

While most of us would have advised the taxpayers in this case that they simply were not qualified as real estate professionals, it is important to remember what are the issues for those who do claim enough hours. The inadequate records mentioned by the court in this case are normally a key problem for taxpayers who try to claim the real estate professional status. A failure of record keeping will become a failure to obtain the tax benefit.

We also have the problem of taxpayers who have a main business, as the husband did in this case, that are not generating qualified real estate hours. His HVAC business was not a real estate business as defined by section 469. So even if he had put in more than 750 hours to the rental activities, he still would not have been a real estate professional due to the hours involved with the HVAC business.

Finally, note that the taxpayers did not make the election to aggregate their rentals. Had they been found to be real estate professionals their failure to aggregate the activities would have made it more difficult for them to show material participation in one or both of the rentals. In that case it is very possible that even though they would have been real estate professionals, the losses from the rentals would still have been passive losses.

All of these factors are things to remember when you have clients who claim to have the 750 hours necessary to at least get to the discussion of whether they are real estate professionals.

[1] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple-were-not-real-estate-professionals%3b-rental-losses-denied/7ddnw (retrieved April 21, 2022)

[2] IRC §469(c)(7)(B)

[3] IRC §469(c)(7)(B)

[4] IRC §469(c)(7)(C)

[5] IRC §469(c)

[6] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022

[7] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022

[8] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022

[9] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022

[10] Sezonov v. Commissioner, TC Memo 2022-40, April 20, 2022