A preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached.

An accredited investor is an individual or entity that meets certain criteria set by financial regulatory bodies, typically in the context of investing in securities that are not registered with regulatory authorities like the Securities and Exchange Commission (SEC) in the United States. Accredited investors are deemed to have sufficient financial sophistication and resources to understand and bear the risks associated with certain types of investment opportunities.

In the United States, to qualify as an accredited investor, an individual must typically meet one of the following criteria:

1. Income Test: The individual has had an annual income of at least $200,000 ($300,000 for joint income with spouse) for the past two years, with the expectation of earning the same or higher income in the current year.
2. Net Worth Test: The individual has a net worth exceeding $1 million, either individually or jointly with their spouse, excluding the value of their primary residence.

Entities such as certain types of financial institutions, trusts, and certain types of corporations may also qualify as accredited investors based on their assets or other criteria.

The rationale behind accrediting investors is to protect less financially sophisticated investors from the risks associated with certain types of investments, such as private placements or hedge funds, which may not be subject to the same level of regulatory scrutiny as publicly traded securities. By requiring accredited status, regulators aim to ensure that investors are able to understand and bear the risks involved in these types of investments.

The following is a practical example.

John is a doctor with an annual income of $240,000 (which places him in the federal tax bracket of 32%). He invests $100K into a BoxHouse Village. John then receives a K1 for $100K in depreciation. This entire depreciation can offset John’s W-2 taxable income, reducing it from $240,000 to $140,000 (now placing him in the federal tax bracket of 24%). To summarize, John has now reduced his annual income, dropped a tax bracket, reduced his tax payment, and earned a return on his initial investment.

This works because of special IRS rules created for investors in hospitality-type projects. As an investor in the project comes the ability to log into the booking management system, where they can run reports and monitor vacancy and nightly rental rates. The investor can also change rates, address guest concerns, and other active participant duties. Being an active participant in investment management will qualify John to take a deduction against his W-2 income.

www.irs.gov – See section “Material Participation”