Forming a real estate investment club with friends to pool funds and invest in property can provide tremendous opportunities to build wealth together. However, real estate clubs involve navigating a complex regulatory landscape at both federal and state levels. Failure to properly structure and operate your club in compliance can jeopardize the entire endeavor and lead to harsh penalties.
In this basic guide, we’ll delve into the key regulations real estate investment clubs must follow, including securities exemptions, ongoing reporting rules, real estate regulations, as well as best practices for remaining compliant. The goal is to provide club founders, officers, and members with the information needed to successfully launch and operate a real estate investment club.
Federal Securities Exemptions for Real Estate Clubs
Two crucial federal securities laws real estate investment clubs must address are:
Investment Company Act of 1940
This Act governs firms primarily engaged in investing and trading securities. Under the Act, securities definitions encompass real estate when acquired and held for investment purposes.
Given their purpose of pooling funds to purchase investment properties, real estate clubs may potentially meet the criteria of an “investment company” under the 1940 Act. But full registration as an investment company is infeasible for small real estate clubs.
How Real Estate Clubs Gain Exemption
Instead, real estate clubs rely on exemptions like:
- Section 3(c)(1) exempts clubs with less than 100 accredited investors and no public offerings.
- Section 3(c)(7) exempts companies owned exclusively by “qualified purchasers” with $5M+ in investments.
By restricting membership and avoiding public fundraising, real estate investment clubs can generally utilize exemptions to avoid full registration under the Investment Company Act.
Securities Act of 1933
This Act mandates registering the “offer and sale” of securities with the SEC. Membership shares in real estate investment clubs constitute securities.
Absent an exemption, clubs would need to register and provide a detailed prospectus to members. But registration is cumbersome and costly for small clubs.
Private Offering Exemption
Instead, real estate clubs take advantage of Rule 506 private offering exemptions under Regulation D of the Securities Act. By:
- Avoiding general solicitation of membership shares
- Vetting members to confirm accredited status or investment sophistication
- Making necessary SEC filings like Form D
Real estate clubs can avail of the Rule 506 exemption to avoid full federal registration and sale of membership shares to members.
Sample Form D Filing
Below is an excerpt of a Form D a real estate investment club could file to notify the SEC of a Regulation D exempt offering:
Name of Issuer: Venture RE Investment Club LLC
Amount of Investment Offered: $550,000
Type of Security Offered: Membership Interests
Exemption Claimed: Rule 506(b)
Purpose of Offering: Raise investment capital for acquisition of real estate properties in Ventura County, California.
This provides a simple template for the basic Form D filing required within 15 days of first selling membership interests to members.
Compliance Tip: Work closely with qualified securities counsel to confirm your real estate investment club satisfies all requirements to claim Regulation D exemptions. Technical lapses can jeopardize exempt status.
State Securities Exemptions
In addition to federal exemptions, real estate clubs must also confirm exemption from registration requirements under applicable state Blue Sky laws.
Common state law registration exemptions real estate investment clubs utilize include:
- Investment club size limits (e.g. under 15 members)
- Restrictions on general solicitation
- Limits on offering amounts
- Intrastate exemptions when activities limited to in-state
For example, California Corporations Code 25102(f) exempts clubs under 35 members fully located and doing business in California.
Clubs must carefully review their state Blue Sky Laws to identify and qualify for the appropriate registration exemption. Otherwise burdensome state registration and prospectus requirements apply.
Sample California Filing
Below is an excerpt from the one-time filing California requires exempt real estate clubs to submit within 30 days of receiving any funds:
California Charitable/Investment Club Statement - Form F-95
Club Name: Venture RE Investment Club LLC
Number of Members: 8 individual members
Purpose: Pool membership funds to invest in residential income properties in Ventura County, CA.
Work with counsel to ensure you make any required state filings to maintain exempt status.
Ongoing Reporting Requirements
Even once operational, exempt real estate investment clubs must fulfill ongoing reporting requirements. Key federal filings include:
Federal Filings
- Form D - Must file within 15 days of new securities sales and renew annually
- Schedule 13G - If the club acquires 5%+ beneficial ownership in a public company
State Filings
- Annual financial statements - to confirm club is properly operated
- Tax returns - to report income, deductions, and member distributions
- Fees and amendments - to maintain exempt status over time
Non-compliance risks
Failing to fulfill ongoing reporting obligations can lead to:
- Loss of exempt status
- Requirement to register belatedly
- Tax penalties and interest
- Rescission rights for members
So compliance with all ongoing filing requirements is essential.
Special Rules for Real Estate Investment Trusts
Some real estate clubs explore structuring as real estate investment trusts (REITs) to access tax benefits like avoidance of corporate income tax.
But electing REIT status involves major additional regulations, including:
- Must have at least 100 members
- No more than 50% of shares held by five or fewer members
- At least 75% of assets must be invested in real estate
- Required to distribute 90% of taxable income as dividends
- Must comply with SEC reporting rules for REITs
Given the complexity, most smaller real estate clubs avoid operating as REITs. But those who pursue this structure must engage expert counsel to ensure full compliance. The penalties for non-compliant REITs are quite severe.
Fair Housing and Anti-Discrimination Laws
The federal Fair Housing Act and state fair housing laws prohibit discrimination in housing on the basis of:
- Race or color
- National origin
- Religion
- Sex
- Familial status
- Disability
This includes prohibitions on discriminatory practices in relation to investing in or providing housing and housing-related services.
Real estate investment clubs must ensure they comply with all applicable fair housing laws in areas like:
- Selecting properties to acquire
- Setting policies for tenant screening and selection
- Making availability determinations for housing units
- Setting terms and conditions for housing related services
Best Practices
To avoid fair housing violations, real estate investment clubs should:
- Formally adopt anti-discrimination policies
- Train club officers on fair housing practices
- Document selection criteria and decisions
- Consult counsel before taking any action regarding protected classes
State and Local Real Estate Regulations
Besides securities laws, real estate investment clubs must contend with many state and local regulations that govern real property transactions and ownership, such as:
- Zoning laws
- Noise and nuisance ordinances
- Rental and eviction regulations
- Occupancy permits
- Property taxes
- Transfer deeds processes
- Inspection and code compliance
- Homeowners association rules
Non-compliance with these types of local real estate rules can derail club investments and lead to fines or forced divestment. Clubs must budget for legal guidance to navigate unique regulations in all jurisdictions where they own property.
Zoning Example
If a club purchases a property zoned for residential use, then attempts to operate it commercially, this likely constitutes a zoning violation prompting fines, shutdowns, and potential forced sale. Clubs should verify property zoning aligns with intended use.
Tax Considerations for Real Estate Investment Clubs
Forming a real estate investment club with others is an appealing way to pool money and invest in property together. But behind the excitement of acquiring real estate assets, clubs must pay careful attention to tax compliance. Failure to properly structure and handle taxes can result in harsh IRS penalties, double taxation, or even loss of pass-through status.
In this comprehensive guide, we’ll explore key federal and state tax regulations real estate investment clubs must follow, including:
- Electing proper tax status
- Pass-through taxation of income and losses
- Tax reporting requirements
- Withholding rules for rents and distributions
- Depreciation deductions
- Self-employment taxes
- State and local property taxes
Understanding tax rules applicable to real estate investment clubs enables properly handling filings, payments, and compliance from the outset.
Choosing a Tax Structure for Real Estate Investment Clubs
Most real estate investment clubs choose to structure as pass-through entities for federal tax purposes. Common options include partnerships, limited liability companies (LLCs), and S corporations.
The key benefit of pass-through status is avoidance of double taxation. With C corporations, income is taxed first at the corporate level then again when distributed to shareholders. But as pass-through entities, real estate clubs avoid entity-level taxes.
Instead, net income, gains, losses, and deductions from the real estate activities “pass through” to members to report on their personal tax returns. Each member pays taxes on their allocated share at their individual income tax rate.
Federal Tax Classification for Real Estate Investment Clubs
To qualify for pass-through partnership taxation, real estate investment clubs must properly classify the entity by:
- Choosing an eligible structure - partnerships, LLCs, and S corps all qualify
- Filing necessary tax elections - typically Form 8832 for LLCs to elect corporate taxation if desired, and Form 1065 to elect partnership taxation
- Having two or more members - single-member entities are disregarded entities
- Operating for profit - investment clubs exist to invest in real estate for financial gain
- Filing annual partnership tax returns - Form 1065 to report income, deductions, and partner distributions
- Issuing K-1s to members - reporting each member’s allocated share of pass-through items
Taxation of Rental Real Estate Income & Expenses
A major tax advantage for real estate investment clubs structured as partnerships or S-corps is the ability to pass rental real estate income, expenses, deductions and credits through to members to use on their personal returns.
Common pass-through items from rental properties include:
- Rental income - taxed at each member’s individual rate
- Mortgage interest - reduces taxable income
- Depreciation deductions - can be accelerated to offset taxes
- Property taxes - deductible expenses
- Repairs & maintenance - deductible operating expenses
- Improvements - may need to be capitalized
- Operating expenses - like insurance, utilities, are deductible
Consult a tax professional to maximize the deductions available for the club’s rental properties.
Tax Considerations When Selling Real Estate
When a real estate investment club sells properties at a gain after holding them long-term, favorable capital gains rates generally apply:
- 0% for taxpayers under 12% bracket
- 15% for taxpayers over 12% but under 37% bracket
- 20% for taxpayers in 37% bracket or higher
These lower long-term capital gains rates provide a key tax advantage versus ordinary income rates up to 37%.
However, gains from real estate held short-term does not qualify for long-term capital gains rates. The exact holding period threshold depends on the property use:
- 1 year for capital assets like stocks
- 1-4 years for collectibles
- 5 years for unrecaptured section 1250 gain real estate
maximize long-term gains by avoiding short holding periods. Consult a tax professional when selling properties.
Tax Reporting Requirements for Real Estate Investment Clubs
Even with pass-through status, ongoing tax compliance obligations apply for real estate investment clubs, including:
Annual Partnership Tax Return
- File Form 1065 annually
- Report income, deductions, gain/loss from sale of properties
- List names and ownership percentages of members
Schedule K-1 Issued to Each Member
- Reports member's allocated share of pass-through items
- Includes income, deductions, credits to transfer to personal return
Tax Withholding & Remittance
- Withhold and remit employment taxes for any club employees
- Potentially withhold & remit taxes on rental income paid to non-US members
- Remit applicable state/local income taxes
Maintain Supporting Records
- Keep detailed records on income and expenses for each property
- Track member capital accounts and changes in ownership percentages
Self-Employment Taxes for Real Estate Investment Club Members
Because most clubs are partnerships, members must pay self-employment taxes on their allocated share of club earnings.
Self-employment tax rates are 15.3% on the first $147,000 of net income to fund Social Security and Medicare. Taxable income above $147,000 is subject to just the 2.9% Medicare tax.
Paying self-employment taxes ensures members earn Social Security credits and eventually qualify for benefits.
State & Local Taxes for Real Estate Investment Clubs
In addition to federal taxes, real estate investment clubs must comply with diverse state and local tax rules:
- State income taxes - many states impose income tax on pass-through business income
- Property, transfer, & deed taxes - levied when acquiring or transferring property
- Rental taxes - some locales tax gross rental receipts
- Franchise taxes - charged annually simply for the privilege of operating
Determining tax obligations across multiple jurisdictions can be complex for multi-state real estate investment clubs. Engage tax professionals familiar with each state and municipality in which the club invests.
FAQs - Real Estate Investment Club Regulations
Do all club members need to be accredited investors?
No, but having exclusively accredited members simplifies qualifying for exemptions. Clubs admitting non-accredited members must perform extra diligence to confirm investment sophistication.
Can our real estate club advertise and solicit publicly?
Likely not, as public solicitation disqualifies clubs from key securities exemptions. Clubs should restrict membership offers to personal contacts only.
Can we form a club under 20 members to avoid securities issues altogether?
Unfortunately no, as federal and state securities regulations still apply regardless of club size. Limiting membership helps qualify for exemptions but does not fully exempt clubs from applicable regulations.
How much income can our real estate club earn without being taxed?
Real estate clubs are generally taxed as pass-through entities with income reported on members’ personal returns. Certain structures like REITs involve different tax treatment.
Conclusion
Forming and operating a real estate investment club involves navigating a complex maze of securities, tax, and property regulations. But with proper structuring and guidance from experienced legal counsel, clubs can successfully comply with requirements and achieve their investment objectives. The key is conducting diligence upfront to make informed decisions and avoid missteps. We hope this guide provides a strong foundation as you embark on your real estate investing journey.
FAQ
What are the key steps for forming a compliant real estate investment club?
The most crucial initial steps when forming a real estate investment club are:
- Engage experienced securities counsel - Forming a compliant club requires navigating complex securities regulations, real estate laws, and tax rules. Securities counsel plays a vital role advising on optimal structure, preparing offering documents and operating agreements, obtaining federal and state registrations/exemptions, and ensuring formalities are handled properly. Expect to invest significant upfront legal fees forming a club.
- Choose appropriate entity structure - Most clubs form as LLCs, partnerships, or S-corps for pass-through taxation, but each have tradeoffs. Counsel can help determine optimal structure aligned to your activities and state laws.
- Obtain EINs, file formation documents - Your attorney can assist with steps like obtaining federal and state EINs, filing articles of organization or incorporation, drafting operating agreements, issuing membership shares properly under exemptions like Rule 506, and making necessary regulatory filings.
- Address upfront tax compliance - In addition to securities filings, clubs must address tax elections like taxation as a partnership or S-corp. Counsel fluent in securities, corporate, and tax laws facilitates compliance.
Covering these key bases from the start helps real estate clubs form compliantly on a solid legal foundation.
Can a real estate investment club take out mortgages on properties?
Yes, utilizing mortgages or other financing vehicles to acquire properties is a common practice for real estate investment clubs. However, clubs should be aware of regulations that limit the number of members in clubs using pooled investor funds for investments beyond just real estate, such as mortgages, development projects, partnerships, etc.
Under federal and state real estate syndication laws, clubs investing in mortgages may be limited to 35 unaccredited investors total across the country, or 35 unaccredited investors per state under intrastate exemptions. Going beyond these limits can require involved registration processes.
Experienced securities counsel can advise real estate investment clubs on structuring their activities related to mortgages, partnerships, or other investments dealing with pooled member funds in order to stay compliant with applicable real estate syndication and securities regulations.
What are the trade-offs of an LLC versus partnership structure?
LLCs and partnerships have key differences real estate investment clubs should consider:
LLC
- Provides liability protection - members' personal assets shielded
- More state filing requirements - articles of organization, annual reports
- Slightly more complex to establish and maintain
- Can elect corporate or partnership tax treatment
Partnership
- No liability protection - members exposed to greater personal liability
- Fewer state reporting requirements
- Simpler and lower cost to establish
- Pass-through partnership taxation treatment
Many clubs opt for LLCs to limit legal exposure to members' personal assets. But others prioritize the flexibility and simplicity of partnership taxation.
Consult closely with your attorney and tax advisor to determine if an LLC, partnership, or other structure like an S-corp makes the most sense based on your club's goals, state laws, and investor mix.
Can a real estate investment club issue different classes of membership shares?
Yes, real estate investment clubs generally can issue different classes of membership shares, with different rights and privileges attached to each class.
For example, Class A shares could provide full voting rights, while Class B shares may be non-voting but accrue greater dividends. This helps clubs provide incentives to members who contribute larger amounts of capital.
When issuing multiple share classes, clubs should clearly define the rights, restrictions, and economic privileges granted by each class in the operating agreement and offering documents.
Clubs should also be aware that issuing multiple classes of shares can add complexity from a securities regulation perspective. Work closely with legal counsel to ensure your club stays compliant with exemption requirements and applicable federal and state securities laws when issuing different membership share classes.
How should real estate investment clubs handle property management?
Real estate investment clubs should generally avoid directly handling day-to-day property management responsibilities. Taking on property management adds potential legal liability and work capacity burdens for the club.
Instead, it is advisable for investment clubs to hire experienced professional property management companies to handle tasks like:
- Marketing vacancies and securing tenants
- Collecting rent and enforcing lease terms
- Coordinating maintenance and repairs
- Managing contractors and services
- Ensuring compliance with laws and regulations
- Providing ongoing oversight and administration
Clubs should research property managers suited to their specific properties and markets. Look for licensed managers with appropriate expertise at competitive rates.
How should a real estate investment club handle record keeping and financial statements?
Proper record keeping and financial statements are crucial for real estate investment clubs. Clubs should maintain detailed records of:
- Contributions made by each member
- Income and expenses for each property
- Mortgage payments
- Appreciation and depreciation
- Tax deductions and credits
- Distributions issued to members
Clubs must provide members with regular financial statements, at least annually, showing their share of income, gains, losses, deductions, credits, etc. Detailed records also help the club accurately file taxes.
Work closely with an accountant/bookkeeper experienced with partnership taxation and real estate. Maintaining meticulous organized records from the outset prevents issues come tax time.
Can non-US citizens and foreign entities invest in a US real estate investment club?
Yes, U.S. real estate investment clubs can generally admit foreign investors and entities as members. However the club must take steps to comply with regulations including:
- Reviewing visa/permanent resident status of foreign individual members
- Verifying foreign corporate entities are registered to transact in the state
- Reporting investment activities for FIRPTA withholding purposes
- Implementing protocols to identify and reject prohibited investors
- Screening members against OFAC and other watch lists
Proper legal and tax guidance is key to allowing foreign investment in compliance with regulations. The penalties for mistakes can be severe.
What should real estate investment clubs know about securities filing requirements?
Even if exempt from full registration, securities filing requirements for real estate investment clubs include:
- Filing Form D within 15 days of first securities issuance and renewing it annually
- Filing amended Form D for any material changes in the offering
- Making state notice filings as applicable under Blue Sky laws
- Filing Schedule 13G ownership disclosures if acquiring 5%+ beneficial ownership in a public company
- Providing annual reports/financials to state regulators to maintain exempt status
Work closely with experienced securities counsel to ensure you meet all federal and state filing requirements that apply. Even exempt issuers must comply with important reporting rules.
What are the limitations on promotional activities and soliciting investors?
Real estate investment clubs relying on securities exemptions like Rule 506 cannot engage in general solicitation or advertising to promote the club or attract potential members. This includes:
- No marketing on public media like radio, TV, billboards
- No blasting emails to long email lists or cold calls
- No openly advertising on public websites or crowdfunding platforms
Instead, clubs should restrict offers to people with whom the organizers have pre-existing relationships. All promotional activities should be conducted privately through personal networks. This helps comply with restrictions required to maintain exempt status.
Can a real estate investment club trade properties or engage in fix-and-flips?
While real estate investment clubs are formed to acquire longer-term investment property holdings, some clubs also engage in fix-and-flips or shorter-term trading. Clubs should be aware this may potentially trigger dealer status and special regulations under federal and state securities laws.
Additionally, clubs flipping properties within a 12-month timeframe may be subject to ordinary income tax rates instead of lower long-term capital gains rates. Consult closely with counsel to ensure trading and dealer activities comply with applicable laws.
What disclosures should be provided to prospective real estate investment club members?
Robust written disclosures members should receive when considering joining a real estate investment club include:
- Offering circular detailing the club's purpose, structure, investment plan, risks, fees, and more
- Operating agreement covering powers, limitations, responsibilities of the club
- Subscription agreement for members to acknowledge accepting terms
- Access to club financial statements
- Description of redemption/withdrawal rights and procedures
Ensure disclosures provide adequate information for members to make informed investment decisions. An attorney can help craft appropriate documentation.
What are the limitations on club membership size?
The maximum number of allowed members depends on the specific exemptions the real estate investment club relies on. Key membership size limitations include:
- 100 members under the federal private investment company exemption
- 35 non-accredited investors under Rule 506 to avoid accredited investor verification
- Even lower limits under certain state Blue Sky law exemptions
Clubs should consult securities counsel to understand the most restrictive applicable membership size caps based on your particular exemption strategy. Exceeding these limits could require burdensome registrations.
Can a real estate investment club hire employees or contract workers?
Yes, real estate investment clubs can bring on employees like property managers, accountants, administrative staff. They can also engage independent contractors for services like maintenance, construction, etc.
Proper worker classification is crucial - misclassifying employees as contractors carries risks. Clubs should pay applicable employment taxes, report wages, provide workers comp insurance, and follow labor regulations. An HR expert or attorney can advise.
What regulations relate to real estate investment clubs issuing dividends and distributions?
When structured as pass-through entities, real estate investment clubs generally avoid double taxation on gains and income. Profits pass through to members to report on their personal tax returns.
However, regulations still apply when clubs issue dividends and distributions to members, including properly tracking members' income and capital accounts, filing required tax forms like K-1s, and withholding taxes where required.
Work closely with a tax professional to ensure your real estate investment club handles distributions, dividends, and member reporting in compliance with partnership tax rules and regulations.
How are real estate investment clubs taxed federally?
Most real estate investment clubs are structured as pass-through entities like partnerships, LLCs, or S-corps. This means the club itself does not pay taxes on income. Instead, net income, gains, losses, and deductions "pass through" to members to report on their personal tax returns.
What are the requirements for a real estate investment club to qualify as a partnership for taxes?
To qualify for pass-through partnership tax treatment, real estate investment clubs must:
- File appropriate partnership tax elections (Form 1065, Form 8832)
- Have two or more members
- Operate to invest in real estate for profit
- Annually file a partnership return (Form 1065)
- Issue K-1s to members reporting their pass-through share of income, gains, deductions
How are rental properties held by a real estate investment club taxed?
For rental real estate, investment clubs can deduct expenses like property taxes, interest, repairs, depreciation, and pass those deductions through to members to use on their individual returns. Rental income is also passed through and taxed at each member's rate.
How are real estate investment club membership shares taxed?
Typically, members pay taxes when they sell their membership shares at a gain. But ongoing club profits and losses pass through to members' returns annually. Receiving K-1s yearly simplifies member tax filing.
What tax form does a real estate investment club partnership file?
Real estate investment clubs formed as partnerships file an annual Form 1065 informational return. The K-1s issued to members are included with the 1065 filing.
What steps should a real estate investment club take before acquiring property?
Before acquiring a property, clubs should take steps like:
- Conduct thorough due diligence - inspect property, order appraisal, verify zoning and permits aligned with intended use
- Review title and confirm there are no liens or other encumbrances
- If financing, consult lenders and counsel to structure loans properly in the club's name
- Ensure the purchase and ownership structure complies with club legal and tax status
- Have counsel review purchase contracts and entity formation documents
- Verify property insurance requirements are met
Taking these steps helps the club make informed acquisitions and take ownership in a legally compliant manner.
What regulations apply when a real estate investment club wants to sell or transfer ownership of a property?
When selling or transferring ownership of property, real estate investment clubs must navigate regulations including:
- Complying with terms of ownership in entity governance documents
- Obtaining proper member approvals as outlined in bylaws or operating agreement
- Filing applicable transfer taxes if transferring property title
- Paying appropriate taxes on any gains if sold for a profit
- Filing deed transfers and closing processes per state real estate sale laws
- Updating changes in ownership with relevant agencies and regulators
Consult real estate counsel to ensure sale or transfer complies with all applicable entity governance, tax, and property laws.
What steps can real estate investment clubs take to reduce legal risks and liabilities?
Actions real estate clubs can take to reduce risks include:
- Maintaining appropriate insurance policies
- Engaging experienced property management
- Requiring member indemnity agreements and waivers
- Establishing compliance protocols and controls
- Regularly consulting attorneys and tax professionals
- Creating emergency contingency plans
- Filing all required registrations, disclosures, and reports
Prioritizing compliance, accountability, and legal guidance from the outset provides the best protection.
