Becoming an Accredited Investor and Why The Designation Matters

Have you ever wondered why some investors have access to exciting investment opportunities that you’ve never even heard of? These deals were likely only available to “accredited investors” – a designation that opens the doors to a range of investing opportunities that are otherwise closed the general public.

In this article, we take a look at the definition of an accredited investor and explain how you can become an accredited investor. 

Subscribe to the Financial Residency PodcastThe Rationale for Creating “Accredited Investor” Status

Typically, a security cannot be offered for sale in the United States unless it has been registered with the U.S. Securities and Exchange Commission (SEC), a federal regulator of the securities markets. The SEC creates standards and guidelines intended to promote full public disclosure of information and protect investors against fraudulent and manipulative practices in the investment marketplace. 

Securities registered with the SEC are thought to be suitable for the masses, with requirements for certain disclosures that provide transparency into investment opportunities. These securities are more highly regulated, providing a buffer for those who want to invest in these securities but who presumably do not have the technical or professional knowledge to navigate some of these offerings. 

There are some instances where a security is exempt from being registered with the SEC. One of those exclusions is when a security is only offered to accredited investors.

The term “accredited investor” was first defined by the SEC in Rule 501 of Regulation D of the Securities Act of 1933 and updated as part of the 2010 Dodd-Frank Act. We’ll get into the full definition of an accredited investor and what it means below.

Through these regulations, an accredited investor can invest in certain unregistered securities, such as private equity offerings, venture capital, hedge funds, and real estate syndications. Individuals can qualify to be an accredited investor, as can banks, partnerships, corporations, nonprofits, LLCs and trusts. The income/net worth thresholds for an individual accredited investor vary from those of a business entity looking to obtain this designation.

In short, the rationale for creating “accredited investor” status was that these individuals have the financial security to absorb any potential losses associated with investing in unregistered, potentially higher-risk deals. Many of these deals are often illiquid in nature, meaning that an investor cannot simply buy or sell their shares as they could with a stock or bond. There is an assumption that accredited investors have the financial wherewithal to withstand having their capital tied up in illiquid assets. 

Accredited Investor Criteria

So, how do you become an accredited investor? Individuals must meet one of two conditions in order to be an accredited investor. The two ways to qualify are as follows:

  • Earned Income Qualification
    Any individual who has an earned income in excess of $200,000 in each of the two most recent years or joint income of $300,000 or more in each of those years when combined with a spouse. Earning this much for the past two years cannot be a fluke—there must be a reasonable expectation of earning the same amount in the current year.
  • Net Worth Qualification
    Any individual who has an individual net worth, or joint net worth when combined with their spouse, of at least $1 million. When calculating joint net worth with a spouse, it is not necessary that the property be held jointly. 

The SEC provides specific criteria as to how net worth is calculated for a would-be accredited investor. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), included a provision that revised the net worth calculation. According to the new regulations, net worth is calculated as follows:

Value of Total Assets – Value of Total Liabilities (i.e. Debt) = Net Worth

Now, there are some exceptions as to what’s considered an asset or a liability by the SEC, including:

  • A primary residence is not counted as an asset in the net worth calculation.
    This is the most noteworthy change coming from the Dodd-Frank Act. It used to be that the equity in someone’s home could count as an asset, making many more investors meet the definition of an accredited investor. That is no longer the case. The exception to this rule is if an individual purchased securities as an accredited investor prior to July 20, 2010 (the date on which the new Dodd-Frank provision took effect). In those cases, if someone had used their primary residence in calculating their net worth, they’d be grandfathered in as an accredited investor under pre-existing law. (Talk to your financial advisor and/or tax attorney if you think this exclusion may apply to you).
  • Typically, any debt (i.e. a mortgage or home equity line of credit) secured by a person’s primary residence is not counted as a liability in the net worth calculation as long as the fair market value of the person’s residence is higher than the liabilities. In other words, if someone is underwater on their mortgage, the difference between debt and equity is factored into the equation as a liability. Situations like these were common after the Great Recession. Let’s say a person purchased a primary residence for $450,000 in 2007 – arguably the height of the preceding real estate cycle. The person took out a mortgage for $410,000 to purchase the property. When the housing market collapsed in 2008, the home was suddenly only worth $350,000. In that case, the difference between the debt ($410,000) and home value ($350,000) would have been $60,000 – and this amount would have been considered a liability for someone interested in becoming an accredited investor. That said, individuals looking to become accredited investors do not need to get a formal appraisal of their primary residence to determine its not exceed the value of the residence. The reasons for this is to prevent someone from artificially inflating their net worth by converting home equity into cash or other assets that would otherwise factor into the net worth calculation.  But, of course, there’s an exception to this exception! This provision holds true except in the case of taking on fresh debt within 60 days for the sake of purchasing a primary residence. For example, a person decides to renovate their kitchen a month before purchasing securities as an accredited investor. To fund the kitchen renovation, the person takes out a second mortgage worth $75,000. The timing of this new loan means that it will be considered a liability in the accredited investor definition. Conversely, an individual who is relocating for job and purchases a primary residence within 60 days of purchasing securities will not have the debt associated with this acquisition factored into the calculation.
  • Home equity lines of credit do not inherently count as a liability. Just having a home equity line available does not make it a liability according to the SEC. Nor is it considered a liability if there’s an outstanding balance on the home equity line, as long as the HELOC is secured against the primary residence and it has not been drawn upon within the 60 days preceding the purchase of securities as an accredited investor. Here’s an example: a married couple purchases a two-family home in 2013 for $415,000. The home has since significantly appreciated, nearly doubling in value. The couple took out a $100,000 home equity line of credit in 2017 – really for no specific purpose, but rather, just to have cash on hand in the event they need to quickly act on an investment opportunity. The couple owner-occupied the property until 2018, when they moved to a new primary residence. Now, the couple rents both units in their duplex. The home equity line is now against a rental property, not a primary residence. In 2019, the couple wants to become accredited investors. Even though the couple has not drawn against the HELOC (meaning there is no balance owed to the lender), the HELOC will be treated as though it’s a liability according to the SEC definition. This is because the HELOC could be drawn against at any time – thereby drastically increasing the couple’s debt load. Even though the HELOC has zero balance at this time, it could have a balance of $100,000 tomorrow, and because the line is not associated with a primary residence it is considered a liability, per SEC regulations.

Case Studies: Determining Who Is an Accredited Investor

Given the detailed overview above, let’s take a quick look at how these principles would apply in practice to meeting the SEC definition of an accredited investor. 

  • Patrick is an unmarried investor who earns $60,000 per year. He carries $300,000 in student debt. He has $15,000 in a checking account and $50,000 in a 401k but has no other assets.
  • Amanda is an unmarried investor who has earned $260,000 per year over the past two years. She has $200,000 in a Roth IRA, another $50,000 in cash on hand, and approximately $200,000 in home equity despite carrying a mortgage of $250,000. She also has a vehicle that is paid off and worth $9,000.
  • Stu is a married investor with $300,000 in annual joint-income over the past two years. He has $200,000 in outstanding debt (though not a mortgage on his property), another $20,000 in cash, and about $50,000 in home equity with a remaining $250,000 mortgage balance. Stu and his wife also own an 18-unit multi-family property worth approximately $1.2 million which they own outright.
  • Monique is a married investor. She and her husband own their $1.5 million home outright. She has $400,000 socked away in her 401k and another $100,000 in cash in her checking account. She has gold and silver coins worth about $35,000. They own three vehicles, paid in full, worth a total of $75,000. They have no debt. Together, she and her husband earn $290,000 per year.

Let’s put this in chart form so we can better compare apples to apples.

Accredited vs. Sophisticated Investors

As we can see from the chart above, Patrick would not be an accredited investor. In fact, he has a negative net worth. Amanda would be an accredited investor, based on her salary alone, which is above the $200,000 threshold for a single person. Stu would qualify as an accredited investor based on annual income and net worth, the latter of which just barely meets the $1 million requirement. Monique and her husband, despite owning their $1.5 million home outright, cannot count this toward their net worth for the sake of becoming an accredited investor. So although she and her husband have significant equity in their primary residence and $610,000 in other liquid assets, they do NOT qualify as accredited investors. Their income is just shy of the $300,000 threshold needed to be met as a married couple.

Now, let’s assume Monique and her husband wanted to become accredited investors, so they make some changes. They took out a $390,000 loan against their primary residence (using a home equity line) and used those funds to purchase other liquid assets, such as stocks or bonds. Sixty days after doing so, they would be accredited investors. The $390,000 debt on their property would not be considered a liability as long as the debt was in place more than 60 days prior to investing in a deal as an accredited investor.

How to Become an Accredited Investor

OK. Let’s assume you roughly meet the definition of an accredited investor. Now you want to find out about the actual process you must go through to earn the official accredited investor designation.

Well, here’s the rub: there’s no official registration or application process for those looking to become accredited investors. Nor is there an agency that certifies you. Essentially, you self-proclaim your qualification as an accredited investor.

In 2013, the SEC released revised rules instructing firms on how to verify an individual’s accredited investor status. It is up to the sponsor of a deal to determine whether you meet the definition as an accredited investor. The sponsor may simply ask you to fill out a questionnaire which you read and then check a box indicating that you meet the criteria. Companies looking to do more thorough due diligence on accredited investors may ask the potential investor to provide documentation – such as copies of recent tax returns, W2s, or a letter from your attorney, accountant, or financial advisor – to certify that you meet the qualifying criteria for an accredited investor. Whether this documentation is needed depends in large part on the type of investment you’re pursuing.

Anyone interested in becoming an accredited investor should consult with their CPA, tax attorney or financial advisor to confirm your eligibility.

Physician Wealth ServicesAccredited vs. Sophisticated Investors

Those who do not meet the criteria to become an accredited investor are not shut out of these investment opportunities altogether. 

For example, according to Rule 506(b) of Regulation D, private offerings can be extended to an unlimited number of accredited investors and a limited number of non-accredited “sophisticated” investors. 

A sophisticated investor is a high-net-worth individual who doesn’t otherwise meet the SEC definition of an accredited investor. These are people who have robust industry knowledge, and who are considered experienced enough in financial matters to make them capable of weighing the merits and risks of prospective investments. This opens the doors to investment opportunities like pre-IPO securities, hedge funds, and commercial real estate deals. It is understood that a sophisticated investor’s net worth (which may be tied up in their primary residence, therefore not qualifying them as an accredited investor) is high enough for them to weather any potential downside incurred as a result of these higher-risk deals.

The definition of a sophisticated investor is vague and does not have specific criteria as is the case with accredited investors. Once again, sophisticated investors self-certify their status. There is no formal paperwork required to prove that you’re a sophisticated investor (though, a deal sponsor can probe for more information and request documentation of total assets and liabilities and/or experience). 

One of the benefits of being a sophisticated investor is that it opens the door to investment opportunities that one would otherwise be unable to access unless they were an accredited investor. This is an alternative way for people to invest without meeting the SEC’s net worth or income standards associated with becoming an accredited investor.

Ready to Start Investing?

Anyone who thinks they meet the SEC definition of an accredited or sophisticated investor will want to sit down with their advisor and/or tax attorney to discuss the pros and cons of investing in these higher-risk securities. Of course, any investment should be made in the context of your broader portfolio. Your advisor and attorney can steer you in the right direction.

The point today is to understand what it takes to become an accredited or sophisticated investor, and why you might want to do so to find some of the more attractive investment opportunities that might not be available to your peers.