Compliance Requirements for Real Estate Funds

Compliance requirements for real estate funds can be complex. The Securities and Exchange Commission (SEC) and the IRS are two regulatory bodies that impose specific filing requirements on them. Let’s go over these two regulatory bodies’ requirements so you know what to expect if you sponsor a real estate fund.

SEC Requirements

Whether you realize it or not, your real estate fund may fall under the purview of the SEC. In general, when you open a real estate fund, the SEC treats you as if you are issuing securities. This means that (1) you must register to sell securities, and (2) the SEC must approve your calls for capital. Fortunately, there are two exceptions to this rule.

Exception #1: Friends and Family Exemption: Rule 506(b)

SEC Regulation D, Rule 506(b) is also called the “friends and family” or “private placements” exemption.  If you comply with its provisions, you don’t need SEC approval of your offerings or a license to sell securities.

To fall under this exemption, you cannot solicit investment from the public. You can only solicit from people with whom you have an existing relationship. Your investors must self-certify that they are either (1) a sophisticated investor, where they have the knowledge or experience to evaluate a prospective investment accurately, or (2) an accredited investor, where they exceed a certain net worth or annual income.

Under Rule 506(b), you cannot solicit investments from more than 35 non-accredited investors. However, you can otherwise raise an unlimited amount of capital from any number of accredited investors. If you have non-accredited investors in your fund, you need to supply them with specific disclosures and financial statement information.

Exception #2: Crowdfunding Exemption: Rule 506(c)

Under Regulation D, Rule 506(c), you can solicit funds from investors you don’t know as long as they are accredited by a third party. Also known as the “crowdfunding” or “general solicitation” exemption, Rule 506(c) lets you advertise specific offerings if you took reasonable steps to confirm your investors were accredited. These steps might include requesting prior tax returns, reviewing bank or brokerage statements, reviewing third-party appraisals of assets and liabilities, or getting written confirmation from someone qualified to verify an investor’s accredited status.

Under Rule 506(c), there are virtually no limitations to how you market your fund to the public. You can solicit investment in your fund over the internet, on TV, on social media or via other means.

Under both the 506(b) and the 506(c) exemptions, you can raise as much capital as you wish. Your only SEC filing requirement is to file Form D with the SEC within 15 days of your first sale.

While this is not an exhaustive list of all SEC requirements and exceptions, you should engage a competent attorney that understands syndications to advise you when forming or operating a fund.

IRS Filing Requirements

Tax filing requirements will vary based on how you formed your real estate fund. In general, most real estate funds are formed as either LLCs or partnerships. That means you can file your tax return as a corporation (IRS Form 1120), an S corporation (IRS Form 1120S) or a partnership (IRS Form 1065).

If your fund is legally registered as a…
By default, you should
file your tax return as a…
But you can elect to file your tax return as a…

Limited Liability Company (LLC)

Partnership (Form 1065)

C corporation (Form 1120) or S corporation (Form 1120S)

Limited Partnership (LP)

Partnership (Form 1065)

C corporation (Form 1120) or S corporation (Form 1120S)

For partnerships, fund earnings will get reported on the entity’s informational tax return. But the earnings, gains, and losses will flow through to you and your co-investors’ individual income tax returns. Income is allocation based on the partnership/operating agreement and may vary among the partners depending on the level of income and the structure of the fund.

As the fund earns income or recognizes gains or losses on the sale of an investment property, you and your co-investors will pay the associated taxes. Your co-investors will report their portion of the fund’s earnings, gains and losses as passive income on their tax returns. Because their earnings are generally considered passive, their losses may be limited and they could be subject to the net investment income tax (NIIT).

As the fund sponsor, your portion of its earnings, gains and losses may be taxed as active income if you meet the real estate professional criteria. You might also have acquisition fees or asset management fees to report, which will also be taxed as active income. All fee income associated with your fund will be subject to self-employment tax.

In addition to the IRS federal income tax filing requirements, most states have their own set of rules and filing requirements. Additionally, the fund can have a filing obligation based on the tax home of the fund, the state that the real property resides or the residence of the partners of the fund.

Other Compliance Requirements

Of course, the SEC and the IRS are not the only governing bodies you need to think about. For example, there are certain hoops you’ll need to jump through to comply with your bank covenants. If you have outstanding debt, your bank may require regular performance reports, financial statements or forecasts to ensure you aren’t over leveraged.

On the internal business side, you’ll also need to comply with your fund’s operating agreement or partnership agreement. Although these aren’t legal requirements, operating agreements dictate how you run your business. If the state finds you in violation of your operating agreement, you could become personally liable for your entity’s debts.

If you have more questions about what you should be doing as a real estate fund sponsor, reach out to our James Moore advisors. Our real estate CPAs have been working with real estate fund managers, sponsors and investors for years and are more than happy to help you make a plan.


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