Which of These Options Is an Illiquid Investment?

Some investments are easy to buy and sell, while others can take months or even years to convert into cash. The latter are known as illiquid investments, which can be challenging for investors who need quick access to funds. While these assets often offer higher returns, they also carry risks due to their limited marketability.

Criteria to Recognize Illiquid Assets

An investment’s liquidity depends on how quickly it can be sold without significantly affecting its price. Assets that lack an active market or require extensive time to find a buyer tend to be illiquid. One key indicator is the absence of a centralized exchange. Unlike publicly traded stocks, which can be bought or sold instantly on platforms like the New York Stock Exchange or Nasdaq, illiquid investments often rely on private transactions or specialized marketplaces.

Some assets have legal or contractual restrictions that prevent immediate resale. Hedge funds and private placements frequently impose lock-up periods, restricting investors from withdrawing funds for a set timeframe. Limited partnership stakes in businesses may require approval from other stakeholders before a sale can occur.

Transaction costs also reduce liquidity. Real estate, for example, involves closing costs, agent commissions, and potential capital gains taxes, making quick sales impractical. Complex ownership structures, such as trusts or joint ventures, can further delay transactions.

Examples of Illiquid Holdings

Certain investments are difficult to sell due to their structure, market demand, or regulatory constraints. These assets often require long holding periods and involve significant transaction costs.

Private Equity

Private equity refers to investments in companies that are not publicly traded. These investments are typically made through private equity funds, venture capital firms, or direct ownership stakes in businesses. Unlike stocks, which can be sold instantly, private equity holdings often require investors to commit capital for extended periods—sometimes 7 to 10 years—before they can exit through a sale, merger, or initial public offering (IPO).

A major reason for this illiquidity is the lack of a secondary market. While some private equity firms facilitate early exits through secondary sales, these transactions are not guaranteed and often occur at a discount. Legal agreements, such as limited partnership agreements, may further restrict transfers or require approval from fund managers.

Private equity investors may also face capital gains taxes upon exit, with long-term gains taxed at rates up to 20% in the U.S. as of 2024. Some investments generate pass-through income, requiring investors to report earnings on their tax returns even if they have not received cash distributions.

Investment Real Estate

Real estate investments, such as rental properties, commercial buildings, and undeveloped land, are another example of illiquid assets. Selling real estate involves listing the property, finding a buyer, negotiating terms, and completing legal and financial due diligence, a process that can take months or even years.

Financing is a major barrier to liquidity. Many real estate transactions depend on buyers securing mortgage loans, which can introduce delays or even cause deals to fall through. Sales also involve significant costs, including broker commissions (typically 5-6% of the sale price), closing costs, and potential capital gains taxes. If a property has appreciated in value, the owner may owe up to 20% in federal capital gains tax, plus additional state taxes.

Real estate investors also face ongoing expenses, such as property taxes, maintenance, and insurance, which can make holding an unsold property costly. Unlike liquid investments, which can be quickly converted to cash, real estate requires careful planning to ensure financial flexibility.

Collectibles

Collectibles, such as fine art, rare coins, vintage cars, and antiques, derive their value from rarity, historical significance, and demand among collectors. Selling these assets can be unpredictable and time-consuming.

Finding a buyer willing to pay the desired price is a challenge. Unlike stocks, which have continuous market pricing, collectibles often require private sales, auctions, or specialized dealers. Auction houses, such as Sotheby’s or Christie’s, may charge seller’s fees ranging from 10% to 25% of the final sale price, reducing net proceeds.

Tax treatment of collectibles is distinct from other investments. In the U.S., long-term capital gains on collectibles are taxed at a higher rate of 28%, compared to the 20% maximum rate for stocks and real estate. Additionally, valuation disputes with tax authorities can arise, particularly for estate planning purposes, where the IRS may challenge reported values.

Because of these factors, collectibles are not easily converted into cash and require specialized knowledge to buy, sell, and store effectively.

Valuation Complexity

Determining the value of illiquid investments is challenging due to the absence of frequent market transactions and standardized pricing. Unlike publicly traded securities, which have readily available market prices, illiquid assets often require subjective assessments that can vary depending on the methodology used.

Many illiquid assets rely on appraisal-based valuations. Privately held businesses, infrastructure projects, and alternative investments require professional appraisals, which depend on assumptions about future cash flows, discount rates, and market conditions. Valuation firms may use discounted cash flow (DCF) analysis, precedent transactions, or comparable company multiples, each of which can produce different results. Because these approaches depend on projections and estimates, they are inherently less precise than market-driven pricing.

Regulatory frameworks add another layer of complexity. Accounting standards such as the Financial Accounting Standards Board (FASB) ASC 820 require fair value measurements for financial reporting, categorizing assets into a three-level hierarchy. Level 1 assets have observable market prices, Level 2 assets rely on indirect inputs, and Level 3 assets—where most illiquid investments fall—depend on unobservable data and managerial judgment. This classification affects financial statements, investor disclosures, and risk assessments.

Tax authorities also scrutinize valuations for estate planning, charitable donations, and business transfers to prevent undervaluation for tax benefits. The IRS may challenge reported values using its own valuation specialists, leading to potential disputes and penalties. Under Section 6662 of the Internal Revenue Code, a valuation misstatement can result in penalties of 20% to 40% of the underpaid tax, depending on the degree of misstatement. Investors and businesses must ensure valuations are well-documented and supported by credible methodologies to withstand regulatory scrutiny.