There are lots of investment opportunities that anyone can participate in, provided they have the money to invest. For example, anyone with a brokerage account can invest in publicly traded stocks, mutual funds, exchange-traded funds, bonds, and more, and there really aren’t any specific qualifications to be able to buy an investment property.
On the other hand, there are some types of investments that aren’t available to the general public. For example, many people can’t simply decide to invest in a hedge fund, even if they have a good amount of extra cash sitting around. The same can be said for most private equity deals, venture capital funds, and crowdfunded real estate opportunities.
To participate in these types of investments, as well as others that choose not to adhere to SEC registration requirements, you’ll need to be an accredited investor. While this generally means that an investment opportunity is restricted to sophisticated investors only, there are specific guidelines that separate accredited investors from the general public.
What is an accredited investor?
The basic idea is that an accredited investor refers to an individual or other entity that has a minimal level of financial sophistication. Some investment opportunities that are perceived as risky, or that don’t want to submit to SEC registration guidelines, are only open to accredited investors. The reasoning is twofold:
- Accredited investors tend to be more financially savvy than the average person. In other words, an accredited investor is more likely to know the basics of how to evaluate investment opportunities and to do their homework before putting money into an investment.
- Accredited investors are either high-asset or high-income. We’ll get into the exact definitions in a bit, but the point is that these investors have more cushion to absorb losses if an investment turns sour. For example, if someone with $50,000 in annual income and no savings loses $10,000, it’s a completely different situation than if someone with a million-dollar portfolio experiences a loss of the same amount.
Now, this admittedly isn’t a perfect method of protecting investors. Not all people who have high incomes or lots of assets are financially savvy, but they are better equipped to bounce back from losses than the average American.
The most well-known investment vehicles that are restricted to accredited investors are hedge funds; however, many private equity and venture capital deals are also restricted. On the real estate front, most crowdfunded real estate opportunities are limited to accredited investors.
Are you an accredited investor?
For individuals, there are two ways to qualify as an accredited investor. And only one of the two needs to be satisfied.
The first way is by the income test. An investor with income greater than $200,000 or a married couple with income greater than $300,000 meets the definition of an accredited investor. They must have met this requirement for the two preceding calendar years and must have a reasonable expectation of meeting the requirement in the current year.
One key point to know about the income test is that you need to use the same type of income (individual or combined) for all three years. In other words, if you and your spouse both earned $175,000 each for the past two years, but your spouse isn’t working at all this year, you can’t use the combined income test to qualify.
To clarify, this refers to your gross income -- not your adjusted gross income (AGI) or taxable income.
The second way to qualify as an accredited investor is through your net worth. An individual or married couple with a $1 million net worth excluding their personal residence can be an accredited investor. The idea here is that you have at least a million dollars in investable assets.
To calculate your net worth for the purpose of accreditation, you can include any assets besides your personal residence. Your investments are obviously included, but remember to also include the value of any other assets you may have such as real estate you own for investment purposes. And since this is net worth, remember to subtract any liabilities you might have other than a mortgage on your primary residence.
In most cases, it’s pretty easy and straightforward to determine if you’re an accredited investor. However, there are always borderline cases where it might not be so easy. For example, if you have a net worth of $1.1 million but $200,000 of that amount consists of tough-to-value assets, you may have a difficult time when trying to prove your accreditation.
As a final point, whichever qualification you use is likely to be vetted by investment managers when you attempt to use your accredited investor status. So be realistic and don’t inflate the numbers.
How do you register as an accredited investor?
The short answer is that you don’t register with any governing body. There’s no central regulatory agency that grants accredited investor status, or that verifies that investors can participate in opportunities that are restricted to accredited investors only.
The point is that you should plan on having to verify your accredited investor status every time you want to take advantage of a restricted investment opportunity, as the SEC mandates that anyone selling an unregistered investment opportunity must take reasonable steps to verify that their investors are in fact accredited. This typically involves filling out a questionnaire to determine your status, as well as submitting documentation that backs up your answers.
For instance, if you claim accredited investor status through the income test, you may be asked to submit things like your past two tax returns and some recent pay stubs. If you use the net worth test to claim accredited investor status, you might be expected to provide brokerage and other financial account statements, as well as documentation for any other assets you include in your net worth.
It’s worth mentioning that if you choose investment opportunities that are listed on the same third-party platform, you may be able to do a one-time accreditation verification. For example, an investment platform may ask you to document your accredited investor status, and it will be valid on that platform’s investment opportunities for a certain length of time.
Why does it matter?
Let’s be perfectly clear. The accreditation standards required to take advantage of unregistered investment opportunities are in place to protect you, not the investment companies. So you can expect the investment companies to be quite thorough when verifying your accreditation status.
And if an investment is restricted to accredited investors only, it’s important to realize that there’s likely to be an elevated level of risk due to the lack of required transparency that these investment companies have and the generally riskier nature of hedge funds, private equity, and crowdfunded commercial real estate.
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