Accredited investor status and how to qualify

In short

A friend of mine once told me he felt left out because a deal he heard about at church was open only to "accredited" people. If you have wondered what that word means, you are in good company. The label comes from federal securities rules, and it decides who may buy certain private investments that are not sold to the general public. A person can qualify through income, through net worth, through certain professional licenses, or through the type of entity that holds the money. The net worth test leaves out the value of the primary home. The Securities and Exchange Commission, known as the SEC, sets the rules, and its Regulation D, Rule 501 is the place to read them. Nobody has to apply to the government for the status, but the company selling the investment must check that a buyer qualifies.

The whole of it

What it is

I once watched a neighbor try to buy a stake in a friend's startup, only to be told the owner could not sell it to him. That surprised us both, and the reason is worth knowing.

Federal law requires most investments sold to the public to be registered with the SEC. Registration means a lot of paperwork and public disclosure. Small private companies and funds often skip it by selling only to people the rules treat as able to look after themselves. The rules call these people accredited investors. The idea is that someone with more income, more savings, or specific training can better judge a risky deal and absorb a loss.

That is the whole purpose. It is not a measure of your worth as a person. It is a line drawn by regulators, and plenty of thoughtful folks fall on either side of it.

How it works

If you are holding a private deal in your hands, the seller has a job to do. Under Rule 506 of Regulation D, the seller must either take reasonable steps to confirm that each buyer is accredited, or limit the sale in other ways. Some offerings allow a small number of buyers who are not accredited, but those carry extra disclosure duties for the seller. Many sellers avoid the trouble and sell only to accredited buyers.

There are several ways to qualify. A person can meet an income test, a net worth test, or a professional test. An entity, such as a trust, a company, or a plan, can qualify on its own terms, often by holding assets above a set level. Each path stands alone. You only need to meet one.

The income test looks at earnings in each of the last two years. It also asks whether the person reasonably expects the same level in the current year. For a married couple, the test counts joint income. The net worth test adds up everything you own and subtracts everything you owe. It leaves out the value of your primary home, and the debt secured by that home is generally left out too, up to the home's value. The professional test is different. It looks to holders of certain licenses in good standing, which the SEC names, such as the Series 7, Series 65, and Series 82. It also covers some people who work for the private fund they are investing in.

Verification is where many people get surprised. The seller may ask for tax returns, pay records, bank and brokerage statements, a credit report, or a letter from a lawyer, accountant, or registered adviser. A seller who limits a sale to accredited buyers and publicly advertises it must take more steps than a seller who finds buyers through private relationships. Honest answers matter here. The buyer who stretches the truth carries the risk, and the seller carries it too.

The numbers, and where to find yours

The income test uses a dollar figure of the current figure, which the official source publishes each year for a single person. For a married couple counting joint income, the figure is the current figure, which the official source publishes each year. The net worth test uses the current figure, which the official source publishes each year, counted without the primary home. Do not guess at these. They are set in the SEC rules, and the site fills in the verified figure with its source and date.

To find your own numbers, start with your tax returns. Look at the income line for each of the last two years. Then make a simple list of what you own, such as bank accounts, brokerage accounts, retirement accounts, and other property. Next, list what you owe, such as car loans, credit cards, and loans on anything besides your home. Subtract the second list from the first. Leave out your home's value from the assets and treat its mortgage under the rule described in Regulation D. If you are unsure how a mortgage is treated, ask a securities lawyer or a tax professional.

A worked example

Let me tell you about a woman named Dolores. She is a nurse practitioner who lives in Ohio. A colleague invited her into a small real estate fund that sold only to accredited investors. Dolores had never heard the term and wondered if she was on the wrong side of the line.

She started with income. Her tax returns showed $168,000 two years ago and $174,000 last year. She expected about $176,000 this year. She is single. Suppose the single person income line were $200,000, for the sake of this example only. Her three figures all fall below it, so she does not pass the income test. She did not stop there.

She turned to net worth. She owned a home worth $320,000 with a mortgage of $210,000. That home does not count. Her other assets were as follows: $85,000 in a retirement account, $42,000 in a brokerage account, $18,000 in savings, and $12,000 in a car. That is $85,000 plus $42,000 plus $18,000 plus $12,000, which is $157,000 in assets. Her debts outside the home were a $9,000 car loan and $3,000 on a credit card. That is $12,000. So her net worth, for this test, was $157,000 minus $12,000, which is $145,000. Suppose the net worth line were $1,000,000, again for the example only. She falls well short.

Dolores then checked the professional route. She held no Series license, so that door was closed too. She told her colleague she did not qualify, and the colleague thanked her for being honest. She was not hurt by it. She learned the rule, kept her money where it was, and moved on with a clearer head.

Where it goes wrong

I have seen good people trip over a few things, and none of them make you a bad person.

The first is counting the home. The net worth test leaves out the primary home, so a person with a paid off house and little else may not qualify, no matter how rich the house looks on paper. The second is mixing up one good year with two. The income test asks for the last two years and a reasonable expectation for the current one. A big bonus or the sale of a business in a single year may not be enough. The third is trusting a seller who says, "Just check the box." A seller must take reasonable steps to verify. A form with no questions behind it should make you pause.

Some people also assume that qualifying means a deal is safe. It does not. Private investments can be hard to sell, can carry high fees, and can lose all the money put in. The status only says you are allowed in the door. It says nothing about what is inside the room. Rules may also change, and the SEC has reviewed these definitions over time, so check the current text on the SEC's website before you act.

Questions to answer before you leave this page

Have you looked at your last two tax returns to see where your income really sits? Have you added up what you own and subtracted what you owe, leaving your primary home out of the count? Do you hold a license that the SEC lists, or do you work for the fund you are looking at? Do you know what the seller will ask you to show, and are you ready to show it honestly? Have you read Rule 501 of Regulation D on the SEC's website, or asked a securities lawyer to walk you through it? Can you say, in plain words, what you could lose if the deal goes sour, and would that loss be one you could live with?