Your cousin’s friend has 90,000 dollars sitting in a savings account and no interest in finding tenants. You have found a triplex, you know the block, and you are short on cash. He offers to fund the down payment and the rehab if you handle everything and split the upside. You shake hands, you have an attorney paper an operating agreement, and you close.
You have just done something that may be a securities offering, and almost nobody in that conversation knew it. Not your partner, not your agent, and in most cases not the attorney who drafted the operating agreement, because he drafted an LLC document and the question is not about LLC law.
This is not an exotic risk reserved for people who raise money from strangers on the internet. It is an ordinary feature of the most common structure in small-scale real estate: one operator, one money partner, one property. Whether that structure is a security does not depend on how many people are in it or how much money changed hands. It depends on one thing, and the thing is simpler than the folklore around it suggests.
Structuring a deal with a partner who is funding rather than operating? Send us the structure before you sign it. We will tell you what a lender will want to see. Reach us through our contact page or at 412-990-2941. FMC Capital, NMLS #1840537.
A handshake deal can be a security and a written one can fail to be
The instinct most investors have is that a security is a thing with a prospectus, a broker, and a ticker. That instinct is wrong in a specific and expensive way. The legal definition reaches an “investment contract,” and an investment contract has no required form at all. It can be an oral agreement, a one-page side letter, or a membership interest in an LLC that holds a single duplex.
Conversely, plenty of carefully papered two-member LLCs are not securities, because both members actually run the business. The document is not what decides it. What the members do is what decides it.
That is worth sitting with for a second, because it inverts how investors usually think about risk. The deal you did on a handshake with a passive funder is more exposed than the deal you papered loosely with a partner who swings a hammer.
The test, in the words investors actually use
Courts apply a four-part test, and every part has to be present. Strip the language back and it reads like this.
Someone invested money. Easy, and almost always true when a partner wires a down payment.
The money went into a common enterprise. Also easy. One property, one entity, pooled funds, shared outcome.
The investor expected a profit. True by definition, or he would not have wired anything.
And the profit was expected to come from the efforts of others. This is the whole ballgame. Every one of the first three is satisfied in nearly every real estate partnership ever formed. The fourth is where deals separate.
If your partner expects to make money because you will find the tenant, manage the rehab, handle the lender, and decide when to sell, his profit comes from your efforts. That is an investment contract. If he is expected to participate meaningfully in those decisions, and he actually does, it generally is not.
The line is control, not the dollar amount
Three things investors believe about this line, and none of them is the line.
The amount does not matter. There is no floor. A 25,000 dollar passive interest is as much an investment contract as a 2,500,000 dollar one. Small does not mean exempt; small usually means nobody ever complains, which is a different thing entirely.
The number of partners does not matter either. One passive investor is enough. The count affects which exemption is available, not whether you have a security in the first place.
And calling it a loan does not automatically solve it, though this is the closest of the three to a real answer. A genuine loan at a fixed rate, with a fixed maturity, repayable regardless of how the property performs, is debt and is generally treated as debt. The moment the return floats with the profit, or the repayment depends on the sale, you have moved back toward an equity interest no matter what the document is titled. The distinction between money that goes in as equity and money that goes in as a loan is one your lender will also care about, and we walked through how that actually gets documented in capital contribution or member loan.
What does move the line is participation that is real. Not a consent right buried in the operating agreement that the member has never once exercised, but genuine involvement: a vote on the purchase, a vote on the budget, a say on the sale, access to the books, and a partner with the experience to use any of it.
Three structures and where each one lands
The working partnership. Two investors, both making decisions, both doing work, both on the loan. One sources and one manages, or one handles construction and one handles leasing. This is the structure a lender underwrites as an ordinary joint venture, and it is the one least likely to be an investment contract. It is also the structure where the members are genuinely exposed to each other, which is its own subject.
The silent money partner. One operator, one funder, no operational role. This is the common case and it is the one that most often meets the test. It is not illegal. It is an offering, and offerings need either registration or an exemption.
Tenants in common on the deed. Two names on title, each owning an undivided fractional interest in the real property rather than membership interests in an entity. A true tenancy in common with each owner holding real property and real control is the structure least likely to be characterized as a security, which is one of several reasons it keeps appearing in small deals, and lenders underwrite it on its own terms. It comes with partition risk and a messier exit, so it is a trade, not a free pass.
The exemption most small deals actually rely on
Nearly every small real estate deal that is a security relies on a private placement exemption rather than registration. Registration is not a realistic option at this size; the cost exceeds the deal.
The common federal path limits the offering to accredited investors, prohibits general solicitation, and requires a short federal filing shortly after the first sale. Accredited status generally turns on income or net worth thresholds, and there is a well-worn verification process for confirming it. The prohibition on general solicitation is the one that trips operators most often, because posting the deal publicly, pitching it in an open group, or putting it on a website is solicitation even when the eventual investor is someone you already knew.
There is also a state layer. Most states require a notice filing and a fee when a federal exemption is used, and the filing is usually due within a short window of the first sale. Missing it is common and generally curable.
What matters practically is this: the exemption is not automatic and it is not retroactive in any comfortable sense. It is a set of conditions you either satisfied at the time or did not, and the conditions are mostly about how you found the investor and what you told him, not about how good the deal turned out to be.
What your lender does when it sees a passive member
None of this stops a loan. Lenders finance entities with passive members constantly. But the structure does change what underwriting asks for, and knowing that in advance saves a week.
The operating agreement gets read, carefully. The lender wants to know who can bind the entity, who signs, what consent rights exist, and whether a member can force a sale. That is the same review we described in the operating agreement your lender actually reads, and a passive-member structure makes the signing-authority question sharper rather than softer.
Ownership percentages drive who has to be disclosed and who has to guarantee. Most investor programs require disclosure of every owner above a stated threshold, and a separate set of rules governs who counts as a beneficial owner of your LLC. A passive member above the threshold gets screened whether or not he has ever seen the property.
Guaranty scope is the practical fight. Your money partner wired cash to be passive; he does not expect to sign a guaranty. Many programs will accept the operator alone when the operator’s credit and experience carry the file, which is roughly the same calculus as adding a co-borrower, run in reverse. Some will not. Ask before you promise him anything.
And the loan remains a business-purpose loan either way, which is why you will still sign the business purpose certification and why the file will still skip the consumer disclosures covered in why a rental loan has no loan estimate. Securities law and lending law are separate regimes that happen to meet in your operating agreement.
The math: what the passive money actually costs
Run the deal. A triplex at 395,000 dollars, three units at 1,150 dollars, 1,095 dollars and 1,250 dollars, so 3,495 dollars of gross rent. Seventy-five percent leverage gives a loan of 296,250 dollars. Thirty-year amortization at 7.375 percent puts principal and interest at 2,046 dollars. Taxes 395 dollars, insurance 185 dollars. Total obligation 2,626 dollars, and the coverage ratio is 3,495 divided by 2,626, or 1.33. The loan is comfortable.
Now the equity. You need 98,750 dollars down plus roughly 12,000 dollars of closing costs and reserves, so about 110,750 dollars. Your partner brings 90,000 and you bring the rest plus the work. Monthly cash flow before capital items is 3,495 minus 2,626, or 869 dollars.
Structure one: he is a fifty percent member, passive. He receives 435 dollars a month and half the appreciation, and you have an investment contract to document. Structure two: the same 90,000 dollars comes in as a member loan at nine percent interest-only, repayable on sale. He receives 675 dollars a month, you keep 194 dollars and all of the appreciation, and the equity-versus-debt question gets much simpler. On a property you expect to hold five years and sell at 470,000 dollars, structure one costs you roughly 37,500 dollars of appreciation and structure two costs you about 14,400 dollars of extra interest over the same period.
That gap is the real decision, and it is a cash-flow and tax question before it is a securities question. Run your own numbers in the deal calculator, and if you want the ratio mechanics from the ground up, start here.
Four things to settle before you take the check
Decide honestly whether the partner is passive. Not what the document will say. What he will actually do. If the honest answer is that he will wire money and wait, treat the interest as a security and handle it properly. The cost of doing that correctly on a single-property deal is a conversation with a securities attorney and a filing fee, which is small relative to the alternative. It also means you carry every operating surprise alone, from a long vacancy to a tenant running a business out of the unit, so the agreement should say plainly who decides what to do about it.
Do not solicit publicly. The single most common way a small operator loses an exemption is a post, a pitch at an open meeting, or a page on a website.
Get the governing-law and dispute terms right while everyone is friendly. The clause that decides where a fight happens is worth the ten minutes it takes to read, and the same logic applies to the arbitration and governing-law clauses in your loan documents. While you are in that part of the file, read what the note lets a lender do without a lawsuit, because a confession of judgment clause changes the arithmetic of every dispute downstream of it.
And write the exit before you need it. The most predictable failure in a two-member deal is not the property. It is one member wanting out on a timeline the other cannot meet, which is exactly the situation covered in buying out your partner mid-loan, and the time to agree on the valuation method is now, while nobody needs the money.
Taking on a funding partner and want to know how a lender will read the structure? Send the operating agreement and the deal through our contact page or call 412-990-2941.
FMC Capital LLC, NMLS #1840537. We are a Pittsburgh-based brokerage and we finance investment properties for investors across Pennsylvania and additional states. This article is general information for real estate investors and is emphatically not legal, tax, or securities advice. Securities law is fact-specific, federal and state requirements differ, and the consequences of getting an exemption wrong are serious. Consult a licensed securities attorney before you accept money from anyone. All figures are illustrative examples. Loan terms, rates, and program guidelines vary by borrower and property and are subject to change.