Accredited investor requirements and the four routes

Why the line exists at all

Accredited investor status is not a compliment and it is not a license. It is the boundary of an exemption. Most securities sold in the United States have to be registered with the Securities and Exchange Commission, which is what forces a public company into audited statements, quarterly reporting and a prospectus written to a regulated standard. A private multifamily offering does none of that, because it is sold under an exemption from registration.

The exemption exists on a trade. The issuer is relieved of the registration burden, and in exchange the buyers are limited to people the rule assumes can either absorb a total loss or obtain the information a prospectus would have given them. That assumption is the whole basis of the category. The SEC states the purpose in its own capital raising material: the definition identifies investors who are eligible to participate in offerings that are not registered.

It follows that the test is a proxy, not a measurement of judgment. Nothing in the definition asks whether you understand a distribution waterfall, whether you have read an operating agreement before, or whether the sponsor in front of you is any good. Two of the routes below turn on money alone. Treating the label as evidence of your own competence is the single most common misreading of it, and we return to that at the end of this page.

The income route

The first route is income. Under Rule 501(a) of Regulation D, a natural person qualifies with individual income exceeding $200,000 in each of the two most recent years, or joint income with a spouse or spousal equivalent exceeding $300,000 in each of those years, together with a reasonable expectation of reaching the same level in the current year. The rule text sits in 17 CFR 230.501.

Three details in that sentence do more work than investors expect. The first is each. It is not an average across the two years. A person who earned $260,000 and then $150,000 does not qualify on income, even though the two-year mean clears the threshold comfortably.

The second is the current year expectation. The test looks forward as well as back. Someone who has just retired, sold a business, or moved from salary to equity compensation may satisfy both historic years and still fail, because there is no reasonable basis to expect the same income now.

The third is that the individual and joint figures are separate tests rather than a sliding scale. If you rely on the $300,000 joint number, the offering is being sold to the pair of you on the strength of joint income, and the spousal equivalent language was added so that the category is not limited to married couples. What the rule does not do is let you blend, using individual income for one year and joint income for the other.

The net worth route

The second route is net worth exceeding $1,000,000, individually or jointly with a spouse or spousal equivalent, excluding the value of the primary residence. That exclusion was added by the Dodd-Frank Act and it is the reason the net worth route disqualifies more people than they assume, particularly in high-cost coastal metros where a large share of household net worth is home equity.

The arithmetic is simple in outline: assets minus liabilities, with the house taken out of the assets. What is not simple is what happens to the mortgage, and that is where the SEC has written specific mechanics rather than left it to inference. We deal with it in its own section below because it produces the one genuine trap in this whole definition.

Everything else counts in the ordinary way. Brokerage accounts, retirement accounts, cash, private business interests, investment property that is not your residence, all sit on the asset side at fair value. Credit card balances, auto loans, student debt, margin balances and personal guarantees sit on the liability side. There is no requirement that the assets be liquid, which is worth noticing: a person can be accredited on paper through illiquid holdings and still have no business locking up capital in a five to seven year private deal.

That is a distinction we would rather you draw for yourself before a sponsor draws it for you. Qualifying for an offering and being able to afford it are different questions, and only one of them is in the rule.

The primary residence rules, including the sixty day trap

The SEC publishes a compliance guide devoted to the net worth standard alone, and it sets out three rules that operate in sequence.

First, the asset side: "The primary residence is not counted as an asset in the net worth calculation." That is the Dodd-Frank exclusion, and it is the part most people already know.

Second, the liability side: "Debt secured by the primary residence (such as a mortgage or home equity line of credit) is not counted as a liability in the net worth calculation if the estimated fair market value of the residence is greater than the amount of debt secured by it." The symmetry is deliberate. If the house is out of the assets, the loan against it is out of the liabilities, so a homeowner is not penalized twice.

Third, and only where the property is underwater: "If the amount of debt secured by the primary residence is greater than the estimated fair market value of the residence, then the excess is included as a liability in the net worth calculation." Negative equity is real and it counts against you. Positive equity is invisible in both directions.

The fourth rule is the one almost nobody mentions, and it is the reason this section exists. Per the same guide: "If the amount of debt secured by the residence has increased in the 60 days preceding the sale of securities to the investor (other than in connection with the acquisition of the primary residence), then the amount of that increase is included as a liability in the net worth calculation."

Read that against a common plan. An investor decides to put money into a private deal, draws on a home equity line to fund the subscription, and wires the following month. The draw is an increase in debt secured by the residence within sixty days of the sale, it was not incurred to buy the house, and so the full amount of it lands on the liability side of the very calculation being used to qualify them. The rule is designed to stop someone borrowing their way over the threshold, and it catches good faith cases as readily as engineered ones. If you are considering releasing home equity to invest, the sequence and the calendar matter, and that is a conversation to have with your own adviser before the draw rather than after it.

The professional credential route

Until December 2020 the definition for natural persons was money and little else. The amendments the SEC adopted then, described in its compliance guide to the amendments and effective 8 December 2020, opened a route that turns on demonstrated knowledge instead.

A natural person holding certain professional certifications, designations or credentials in good standing qualifies regardless of income or net worth. The Commission designated three at the outset: the Licensed General Securities Representative, Series 7; the Licensed Investment Adviser Representative, Series 65; and the Licensed Private Securities Offerings Representative, Series 82. The list was written so that further credentials can be designated later by order rather than by rulemaking.

This is the route that best matches the stated purpose of the definition, and it is also the one that quietly undermines the other two. A Series 65 holder with modest savings is accredited. A person with $5,000,000 in index funds and no financial training is also accredited. The rule treats them as the same category of buyer. Knowing that the categories are that different from one another is a reason to be careful about what the label is telling you when a sponsor confirms it.

Insiders and knowledgeable employees

Two further routes turn on your relationship to the issuer rather than your finances.

A director, executive officer or general partner of the company selling the securities is accredited with respect to that offering, and so is a director, executive officer or general partner of that company's general partner. The logic is access. Someone in that seat can obtain whatever a prospectus would have disclosed, so the protection is redundant.

The 2020 amendments added "knowledgeable employees" as defined in Rule 3c-5(a)(4) under the Investment Company Act, in relation to the private fund that employs them. This is narrower than it sounds. It reaches people whose role involves the investment activities of the fund, not everyone on the payroll.

The amendments also added natural persons who qualify as family clients of a family office that is itself accredited, which is the individual counterpart to the entity category described next.

Entities, trusts and family offices

Investors frequently subscribe through a legal entity rather than in their own name, and the entity has to qualify in its own right. The routes are different from the individual ones.

The long-standing category covers corporations, partnerships, limited liability companies, trusts, 501(c)(3) organizations and employee benefit plans with total assets in excess of $5,000,000, provided the entity was not formed for the specific purpose of acquiring the securities being offered. That proviso is the operative one. A holding company created last month so that four friends can pool capital into this deal is not accredited by virtue of the money they are about to put in it.

The 2020 amendments then added a catch-all so that entity types not otherwise listed are not excluded by omission. Any entity owning investments in excess of $5,000,000, again not formed for the specific purpose of acquiring the securities, qualifies. The amendments confirmed limited liability companies with more than $5,000,000 in assets in the definition, resolving an ambiguity that had persisted for years, and added registered investment advisers and rural business investment companies.

Family offices were given their own category: assets under management in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, and with the prospective investment directed by a person who has such knowledge and experience in financial and business matters that the family office is capable of evaluating the merits and risks of the investment. That third condition is a knowledge test written into an entity definition, and it has no analogue in the $5,000,000 asset categories.

If you are subscribing through a self-directed retirement account, the analysis runs through the account and its owner rather than through these entity categories, and the tax consequences are a separate matter we cover in self-directed IRAs and the UBIT surprise.

How status actually gets established

Qualifying and proving are two different exercises, and which one applies to you depends on the exemption the sponsor is using. Investor.gov sets out the distinction between the two paths in its material on private placements.

Under Rule 506(b) the sponsor may not generally solicit or advertise the offering, and may sell to an unlimited number of accredited investors plus up to 35 non-accredited but sophisticated purchasers. Because the offering is not advertised, the sponsor is generally entitled to rely on an investor representation of accredited status, which in practice is a questionnaire you complete and sign.

Under Rule 506(c) the sponsor may advertise publicly, and the trade for that freedom is strict. All purchasers must be accredited, and the sponsor must take reasonable steps to verify it. A signed questionnaire is not sufficient on its own. Verification typically means providing tax returns or W-2s for the two most recent years for the income route, or bank, brokerage and credit report documentation for the net worth route, or a written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney or certified public accountant who has taken reasonable steps within the prior three months.

This is worth knowing before you meet a sponsor, because it explains a request that otherwise feels intrusive. If you were reached through a public advertisement, the offering is almost certainly a 506(c), and the sponsor is not being nosy in asking for your tax returns. They are doing the thing the exemption requires. The full comparison is in 506(b) versus 506(c).

What the label does not do

Accredited investor status carries no protection with it. It is the removal of a protection. Once you are inside the category, the offering you are shown does not have to be registered, does not have to carry audited financial statements, and does not have to disclose in the form or to the standard a public offering would.

It does not mean the investment has been reviewed. It does not mean the sponsor has been vetted by anyone. It does not mean the projections are reasonable or that the assumptions behind them have been tested by a third party. A Form D filed with the SEC is a notice, not an approval, and the Commission does not pass on the merits of any private offering.

It also does not mean the investment suits you. Private real estate is illiquid, and a five to seven year hold usually means exactly that, with no redemption right and no secondary market to speak of. Distributions can be suspended. Capital calls can be made. You can lose the entire amount.

Our own view is that the question worth asking is not whether you clear the threshold, but whether you would still be comfortable with your position if this investment returned nothing at all. That is a question about your circumstances rather than about a rule, and it is one we would rather you settled before you spoke to any sponsor, including us. If you want the sequence we would follow in your position, nine questions before wiring is written for exactly that moment.

What to confirm about your own status

1. Which route am I relying on, and can I evidence it for each of the two required years rather than on average?
2. Is this offering being made under Rule 506(b) or Rule 506(c), and what verification will be required of me?
3. If I am subscribing through an entity, does it hold more than $5,000,000, and was it formed before this opportunity existed?
4. Have I increased any debt secured by my home in the last 60 days, and does that change the calculation?
5. Setting the rule aside, would I be comfortable if this position returned nothing?

What this is built on

1. U.S. Securities and Exchange Commission, Accredited investor, capital raising building blocks
2. U.S. Securities and Exchange Commission, Compliance guide, accredited investor net worth standard
3. U.S. Securities and Exchange Commission, Compliance guide, amendments to the accredited investor definition
4. Electronic Code of Federal Regulations, 17 CFR 230.501, definitions and terms used in Regulation D
5. U.S. Securities and Exchange Commission, Rule 506(b) of Regulation D
6. U.S. Securities and Exchange Commission, Rule 506(c) of Regulation D
7. Investor.gov, Private placements under Rule 506(b) and 506(c)