Liquidity is a key concept in the investment world. As you acquire or sell assets, a critical consideration is how the asset, or its sale, will impact your short- and long-term financial health. Does it expose you to increased risk or protect your financial security? Does the asset generate a regular income, or can you convert it to cash quickly in an emergency?
Liquidity considerations are one factor to consider when building your portfolio, and variations are also significant. So, let’s dig deeper into the concept to answer the question, “What is the difference between liquid and illiquid assets?” Understanding these terms and the advantages and disadvantages of each type will help you make informed decisions about your investments.
Defining the Terms: What Is the Difference Between Liquid and Illiquid Assets?
Liquidity refers to how quickly you can convert an asset to cash. The conversion speed is relative, not absolute. It’s a continuum, and an asset’s liquidity can move up and down the continuum over time. The more liquid the asset, the faster you can convert it to cash while still maintaining its value; the more illiquid an investment, the longer it will take you to turn it into usable currency without losing value.
Understanding the Fundamentals: What Are Liquid Assets?
Some assets mature quickly, increasing value in a short time and delivering a profit if you decide to sell them. These are liquid assets. Liquid assets take little effort to sell, and all interested parties readily agree on their value. Furthermore, interest in these assets increases over time, and there is no shortage of willing buyers.
Liquid Assets Examples
Responses to the question “What is the difference between liquid and illiquid assets?” is sometimes best demonstrated through examples. Liquid asset examples include:
- Money market funds
- Exchange-traded funds
- Short-term government bonds
- Short-term certificates
Hard currencies are the most liquid assets. Even trading forms — such as purchasing U.S. dollars using Canadian dollars — is generally predictable, with the currencies’ values holding relatively steady and maintaining consistent value ratios concerning one another over short periods. However, individual currencies can become volatile and long-term stability is uncertain.
Liquid Assets Advantages and Disadvantages
The biggest advantage of liquid assets is that you can access their value when needed. These assets display significant flexibility. There is little to no holdover between when you purchase them to when you can convert them to cash, providing you with a ready source for an income stream, debt avoidance and emergency expenses. You need liquid assets on hand to maintain financial health and security.
On the other hand, the flexibility and ease of conversion comes with drawbacks. Liquid assets do not provide a high return on investment, exchanging profitability for security. Additionally, the long-term stability of liquid assets isn’t a given. They are responsive to economic fluctuations, making them vulnerable to downturns.
Diving Into Uncertainty: What Are Illiquid Assets?
What is the difference between liquid and illiquid assets when considering salability? The most significant difference is that illiquid assets do not mature quickly, so you can’t convert them to cash soon after a sale without losing value. Furthermore, these assets aren’t always as easy to offload, requiring more time and effort to get money out of them.
Illiquid assets potentially gain value over time, though how much value is uncertain. These assets are challenging to assign a monetary value to, as they are susceptible to changing interests and sometimes only appeal to a small market sector. Furthermore, illiquid assets tend to take longer to sell due to complicated processes or lack of widespread interest.
Illiquid Assets Examples
One answer to the question, “What is the difference between liquid and illiquid assets?” is that illiquid assets are often tangibles. An exception would be most mutual funds. Illiquid assets examples include:
- Real estate and land
- Hedge funds
You can add collectibles such as coins, rare stamps and cars to this list.
Illiquid Assets Advantages and Disadvantages
One of the biggest advantages of illiquid assets is that they potentially offer a much higher return on investment if you hold onto them long enough. Even when the market or economy takes a downturn, these investments usually see a recovery and return to a growth trend.
However, growth is not guaranteed. You may carry a substantial risk with these investments. If you need cash quickly, you won’t be able to rely on selling illiquid investments to get it. A significant disadvantage to these assets is the time and effort it takes to find a buyer and complete a sales transaction.
Another answer to the question “What is the difference between liquid and illiquid assets?” is that if you must sell an illiquid asset fast, you risk losing a substantial amount of money. However, if you can wait to convert the asset to cash until it appreciates significantly, you might be subject to capital gains taxes.
Converting an Illiquid Asset to a Liquid Asset With a Deferred Sales Trust
Investing in illiquid assets undoubtedly confers financial benefits when you hold them long enough to see a considerable return on your investment. However, you might lose some of that benefit to capital gains taxes if the sale nets you a profit that exceeds the Internal Revenue Service’s income threshold.
Fortunately, offsetting and deferring high tax rates from selling illiquid assets is possible. A Deferred Sales Trust transfers your rights and ownership to a tax-deferred trust. Upon the sale, the trustee collects the proceeds. No taxes are paid on money in the trust, and you and the trustee establish a timeline and procedures for installment payments. You will only pay taxes on the amount you receive in payments during any tax year.
Finding Help When Knowing the Answer to “What Is the Difference Between Liquid and Illiquid Assets” Leads to a Change in Strategy
Knowing the answer to “What is the difference between liquid and illiquid assets?” might have you rethinking your strategies to gain the advantages of selling without the disadvantages of high capital gains. Reef Point’s sole purpose is to help people like you convert illiquid assets into liquid assets without incurring immediate and sizable tax penalties through DSTs. If you’d like to learn more about what we do, get in touch today.