Imagine a long-time friend, James, approaches you with an opportunity to purchase a four-unit apartment building together. He’s found a promising property and plans to renovate it, add an accessory dwelling unit, and lease it to tenants.
James asks if you would help fund the purchase price in exchange for membership interest of an LLC that will own the property. He also offers to give you a 20% share of the rental income.
James assures you the deal would require minimal time commitment and that you can take a passive role. One of his family members is also joining the deal, making it an informal family real estate investment.
Family Real Estate Deals and Securities Law
Family real estate investments often begin informally, with friends or relatives pooling funds to buy, renovate, or rent a property. But even these cooperative ventures can create securities issues. When investors take a passive role and rely on someone else’s management to generate returns, the arrangement can cross into regulated territory.
Understanding whether your family real estate project qualifies as a security is crucial for compliance. Failure to recognize and address these obligations early on can lead to enforcement actions, penalties, or recession rights that unwind the entire deal.
Is This a Security?
The short answer is yes, it could. Even one-time, family real estate deals may be considered securities under federal and state laws.
When capital is pooled for an investment, it’s essential for the issuer of the investment opportunity to ask (and comply): “Is this a security?” Most people think of securities as stocks, bonds, or mutual funds. But under Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Act of 1934 define “security” to include an “investment contract,” which can include certain real estate deals.
The U.S. Supreme Court has provided guidance on what classifies as an “investment contract” under U.S. law including with the Howey Test.
Howey Test
The Howey Test comes from the 1946 landmark case in S.E.C v. W.J. Howey Co., where the US Supreme Court considered whether a land-sales contract was considered an “investment contract” under the Securities Act of 1933.
The Howey court established the test for determining whether a particular scheme is an investment contract is, “a [1] contract, transaction or scheme whereby a [2] person invests [their] money in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.” See S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946).
Let’s apply this to James’ proposal:
- Investment of Money: If you are contributing funds toward the purchase, this will likely satisfy the first element.
- Common Enterprise: Courts usually look for either “horizontal commonality” or “vertical commonality.” See Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (1994) (noting that horizontal commonality is “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits” and vertical commonality which look at the “relationship between the promoter and the body of investors”).
If you and James’ family member take a passive role, and James is (on his own efforts) managing the project and leasing it out to tenants, then this could be seen as a common enterprise.
Notably, the SEC has mentioned that it does “not believe that ‘common enterprise’ is a requirement for an investment contract”. In re Barkate, 57 S.E.C. 488, 496 n.13 (2004). Recently, the SEC has applied the common enterprise standard broadly and found that emerging investments like crypto are often a common enterprise.
- Expectation of Profits: A promised 20% share of rental income can establish an expectation of profit.
- Efforts of Others: James is sourcing the property, handling renovations, and managing tenants. If you’re taking a passive role, it is likely the profits are derived from his efforts.
Taken together, these elements suggest the family real estate deal could be classified as an investment contract.
Expanding the Deal: Syndication Risk
Now imagine James adds five more friends and family members to the deal. With multiple passive investors and one active manager, the arrangement begins to more clearly resemble a real estate syndication, a structure that almost certainly triggers securities laws.
Why this Matters
Misclassifying a real estate investment as a simple partnership can have serious legal impacts if securities laws applies. If your deal involves passive investors relying on someone else’s efforts to generate returns, it may trigger federal and state securities laws.
The ramifications include:
- Mandatory filings with the SEC and state regulators
- Financial Penalties for failure to file required filings and other noncompliance issues
- Investor rescission rights, which can unwind the deal and create financial exposure
- State and SEC level actions
Even informal, one-time family real estate deals can fall under securities scrutiny. Identifying and addressing these issues early is critical to protecting your investment and avoiding costly enforcement actions.
Need Guidance?
At Fortra Law, our Corporate and Securities team works closely with real estate investors and private lending funds to navigate complex securities, tax, and regulatory rules. We help structure deals that are compliant, efficient, and tailored to your goals. Contact our team today to safeguard your investment.
