Selling a Rental When You Are Not an Accredited Investor

Run the test as of your closing date, with the rental's equity counted in

Rule 501(a)(5) counts a natural person whose net worth, alone or with a spouse or spousal equivalent, exceeds $1,000,000. The primary residence is left out as an asset and its mortgage is left out as a liability up to the home's estimated value, but any increase in that mortgage during the 60 days before the securities purchase is counted as a liability, and so is any mortgage balance above the home's value. Everything else counts, including the equity in the rental you are about to sell and, after closing, the proceeds sitting with your qualified intermediary.

Rule 501(a)(6) is the income route: more than $200,000 in each of the two most recent years, or $300,000 together with a spouse or spousal equivalent, with a reasonable expectation of the same this year. One strong year does not qualify you. Rule 501(j) defines spousal equivalent as a cohabitant in a relationship generally equivalent to marriage, which matters to unmarried couples who own together.

Two routes people miss: Rule 501(a)(10) treats holders of certain professional certifications the Commission has designated as accredited regardless of wealth, and Rule 501(a)(8) treats an entity as accredited only when every equity owner is. A family LLC or revocable trust therefore does not create accreditation you lack personally. The full set of tests and the proof sponsors ask for is in accredited investor rules for DST investments.

Why most DSTs are closed to you: 506(c) verification and the 506(b) disclosure burden

A DST interest is a security sold in a private placement, which is a DST a security and who can sell one explains. Under Rule 506(c) every purchaser must be accredited and the sponsor must take reasonable steps to verify it, typically two years of tax forms, account statements dated within three months, or a letter from a broker-dealer, registered adviser, attorney or CPA. There is no sophistication exception and no small-ticket exception.

Rule 506(b) is different on paper. It allows up to 35 purchasers who are not accredited in any 90-day period, provided each one, alone or with a purchaser representative, has the knowledge and experience to evaluate the merits and risks, and Rule 501(e) leaves accredited investors out of that count. The catch is Rule 502(b): if a 506(b) issuer sells to even one non-accredited purchaser, it must furnish that purchaser a disclosure package a reasonable time before the sale, with financial statements that follow the Regulation A standards. Most sponsors avoid that obligation by selling to accredited investors only, even in a 506(b) offering.

So the honest expectation is that a DST will not be available to you unless a sponsor has chosen to carry the disclosure burden. Ask directly whether an offering admits non-accredited purchasers; the exemption claimed on the Form D tells you whether that is even possible. Whatever the answer, a DST interest is an illiquid private placement that cannot be resold without an exemption under Rule 502(d), the trust sells when the sponsor decides, and the principal can be lost. Rule 506(b) versus 506(c) sets out the two exemptions side by side.

What you can buy: a whole property, a deeded fraction, or a direct title security

Reg. section 1.1031(a)-3(a)(5) lists fee ownership, co-ownership, leaseholds and easements as real property, and none of them involves a securities offering. A whole rental or small commercial building bought in your own name is the ordinary path, and the answers page on non-accredited replacement options walks through the property types.

A deeded undivided interest in a larger property, held with other tenants in common, is also real property. Groups that follow the guidelines in Rev. Proc. 2002-22, no more than 35 co-owners, unanimous approval of sales, leases and financing, each owner free to transfer its own interest, keep the interest from being treated as a partnership interest, which section 1031 excludes. A co-ownership interest is not a security merely because it is fractional, but a sponsored tenancy-in-common program can be offered as one, so ask how it is sold before you count on it.

The direct title security is a property you own outright through a single-member LLC, with a lease and a property manager already in place, sold with a private placement memorandum and subscription agreement. Because it is offered through documents rather than a listing, confirm before you identify it whether the offering admits non-accredited purchasers; what you own with a direct title security covers the ownership and tax side.

Worked model: $400,000 of rental equity and a seller just under the line

Hypothetical, round numbers. You own your home, worth $700,000 with a $300,000 mortgage, and a rental you are selling for $650,000 with a $250,000 loan. Your other assets, retirement accounts and savings, total $500,000. For Rule 501(a)(5) the home and its mortgage drop out; the rental equity of $400,000 plus the $500,000 of other assets gives a net worth of $900,000. You are not accredited, and the sale does not change that, because $400,000 of equity becomes $400,000 of exchange proceeds.

The income test gives the same answer if you earned $180,000 in each of the past two years. If you earned $210,000 last year and expect the same this year, you pass only once the year before last also exceeded $200,000; the rule requires each of the two most recent years. Joint filers compare household income against $300,000 instead.

With $400,000 of equity and $250,000 of debt paid off, you must acquire at least $650,000 of replacement value and replace the $250,000 of debt or add cash, which do I have to reinvest the whole sale price explains. A $650,000 rental with a $250,000 mortgage does it exactly; so can a direct title security with financing arranged through the offering, if it admits you. Take these figures to your CPA with your own balance sheet before you rely on either test.

The path, and when paying some tax beats a forced purchase

Settle your accreditation status in writing before day 45, because the identification list has to be made of things you can actually close on. Three names of any value, or any number within 200 percent of what you sold, under Reg. section 1.1031(k)-1(c)(4), is the whole budget; a name you cannot buy wastes a slot.

If the only replacements open to you are properties you would not otherwise want, compare the tax on a straight sale with the cost of owning something you dislike for years. Should I do a 1031 exchange at all frames that choice, and a partial exchange that takes some cash as boot is a legitimate middle path.

• Compute net worth excluding the home, and income for each of the last two years, with your CPA.
• Ask every offering, DST or direct title, which exemption it uses and whether it admits non-accredited purchasers.
• Build the identification list from whole properties and any offering that has confirmed it will take you.
• Replace the debt you paid off, or add cash, so the equity is not taxed as boot.