Failure to Meet Real Estate Professional Exception Leads to Passive Loss Limitation

In a recent Tax Court case[1], the Court held that husband and wife taxpayers failed to meet the so-called real estate professional exception to the passive activity rules resulting in the Court denying their excess deductions from rental real estate. The passive activity rules related to rental real estate activities are a little more complex than the standards applied to other activities, and in order for these rental real estate activities to be deemed not passive, the taxpayer must first meet the requirements to be deemed a real estate professional or the activities are per se passive. As discussed below, the taxpayers in this case were unable to meet the qualifications to be a real estate professional and thus had their excess deductions, that is, their deductions in excess of income from the rental activities, denied.


Christian and Francine Sezonov resided in Ohio where Christian ran an HVAC supply company through a single member LLC, Design Build Service, LLC (“DBS”). Christian operated the HVAC company full time and did not have any employees during the years at issue, 2013 and 2014.

In 2013, through DBS, the Sezonovs acquired two properties in Florida to be used as rental properties. One property was acquired in April 2013 and was rented out short term for a few months after they bought it and then rented out pursuant to a 1-year lease in September 2013. The second property was bought in November 2013 and first made available for rent in December 2013, with the first rental taking place in January 2014. This second property was used as a short-term vacation rental, with most rentals being for a one month term.

The Sezonovs both spent time on the properties including things such as improving them, maintenance, cleaning, managing rentals, advertising, and the like, though Francine handled most of the day-to-day type operations of the rentals.

Their 2013 and 2014 returns were audited and their losses that resulted from the two rental properties were denied as passive activity losses. I note there that “denied” may not be the best term to use as they are merely deferred until a time when the couple has sufficient passive income to offset such passive losses.

The Sezonovs challenged the denial of the losses and ended up in Tax Court. The Sezonovs did not have many records related to their activities and time spent on the rental properties, nor did they have any contemporaneous time logs. They prepared estimated time logs in 2019, showing that Francine allegedly dedicated 476 hours to the rental activity in 2013 and 78 hours in 2014. Christian allegedly dedicated 405 hours to the rental activity in 2013 and 27 hours in 2014.


Under §469(a)(1), losses generated from a passive activity may only be used to offset income from other passive activities. To the extent a taxpayer has excess passive losses, that is deductions and expenses in excess of income, such excess losses are disallowed and deferred to a future year when passive income exceeds passive losses. A “passive activity loss” is the excess of the aggregate losses from all of the taxpayer’s passive activities for the taxable year over the aggregate income from all of his passive activities during the taxable year.[2] A “passive activity” is any trade or business in which the taxpayer does not materially participate or any rental activity regardless of whether the taxpayer materially participates in such activity.[3] Although Section 469(c)(2) generally treats all rental activity as passive,  Section 469(c)(7) carves out an exception for the rental activities of certain taxpayers engaged in a real property trade or business, the real estate professional exception. If a taxpayer qualifies as a real estate professional, then the rental activity is treated as a trade or business subject to the material participation requirements of Section 469(c)(1) rather than as per se passive.[4]

Section 469(c)(7)(B) provides that a taxpayer qualifies as a real estate professional for a given taxable year if: (1) “more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates,” and (2) “such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.”[5] In the case of a joint return, these requirements are considered satisfied only if either spouse separately satisfies both requirements, the hours are not combined to determine whether the 750 hour limit is met.[6]

So, for the Sezonovs to overcome the IRS disallowance of their deductions, they first had to prove that at least one of them met the requirements for the real estate professional exception in 2013 and/or 2014, and then they would have to prove material participation in the rental activities after that. Unfortunately, they never got past step one. As noted above, neither had more than 500 hours in 2013, and neither had more than 100 hours in 2014. In determining whether a married taxpayer materially participated in a real property trade or business, but not for any other purpose under Section 469(c), work performed by the taxpayer’s spouse is treated as performed by the taxpayer.[7] However, such is not the case for the real estate professional exception. Unfortunately for the Sezonovs, §469(c)(7)(B) makes it clear that a spouse must meet the real estate professional requirements, including the 750 hour requirement, alone, and time spent by one spouse is not combined with time spent by another spouse for these purposes. Unfortunately, neither of the Sezonovs were able to meet the real estate professional exception and both rental real estate activities, that is, both properties, were held to be passive.

One thing the Court spent a fair amount of time on was highlighting the Sezonovs’ lack of business records and contemporaneous time logs. The Court noted the contemporaneous time logs and records are certainly not required, but they are generally more accurate, and the Court affords them more weight. It didn’t matter in this case, but it’s worth pointing out the Court’s comments on them as they made similar comments in another case issued the same week.[8] That case had to do with an alleged overstatement of gross receipts and proving partnership basis, both items of which the taxpayers were unable to produce any sort of contemporaneous records, instead only producing records in response to the audit inquiries.


As one can see by reading the discussion above of Section 469 as it applies to real estate, the passive activity rules are particularly complex, and much more so for real estate. Since rental activities are treated as per se passive, in order to have rental real estate treated as an active trade or business, taxpayers must first meet the real estate professional exception and then prove material participation in the activity or activities after that. So one can qualify for the real estate professional exception but still fail to materially participate in a rental real estate activity resulting in passive activity treatment even though the real estate professional exception has been met, see below for a prior article were this was the precise result as to three vacation properties that were separately managed.[9]

Proving material participation can be tricky for any business, but it is even more so for rental real estate due to the trap for the unwary, that being that, absent making an affirmative election to combine all rental activities as one, each rental property is considered its own separate activity that is analyzed alone. The effect of this is that it is often really hard to meet the time requirements for material participation (100 hours minimum, usually much more, see discussion on my prior article on this issue)[10] since taxpayers may not spend that amount of time on each individual property. Many taxpayers may not be aware of this election under Section 469(c)(7), and not making it can be costly. Anybody getting into the rental real estate business should seek competent tax advice to make sure they have everything properly structured and are aware of the tax consequences of said structure.

Additionally, as with many cases, this case also serves as a reminder to keep adequate business records and contemporaneous, clear time logs. Deductions are a matter of legislative grace and it is up to the taxpayer to prove that they qualify. Having adequate records to substantiate a tax position, deductions included, will make things go much smoother for a taxpayer should the taxpayer find themselves in an audit. This applies not only to satisfying real estate professional and material participation tests, but also for almost every area of tax law.

[1] Sezonov v. Comm’r, TC Memo 2022-40.

[2] § 469(d)(1).

[3] § 469(c)(1), (2).

[4] § 469(c)(7)(A)(i); see also Aragona Tr. v. Commissioner,  142 T.C. 165, 171 (2014).

[5] Id.

[6] Id.

[7] Treas. Reg. § 1.469-9(c)(4).

[8] Kohout et ux. v. Commissioner, T.C. Memo. 2022-37.




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