Business owners ready to sell their business can often see a windfall of money. For some, this windfall might be plenty to live on during retirement. But others may want or need to find other income-generating strategies to replace their business income. In this article, we’ll review a few income replacement strategies for exit planning.
For the ex-business owner who is looking to take it a little easier after years of hard work, passive investments can be a viable source of potential income. We’ll focus on two potential passive income streams.
First is public securities. These include stocks, bonds, ETFs, and mutual funds. The type of investment you choose depends on your risk profile and financial goals. Outside of appreciation, conservative dividend-paying stocks can be a source of potential income. The same can be said for conservative ETFs and mutual funds since many also provide distributions.
Bonds are another potential area where investors can find income. Treasury bonds are considered risk-free since the U.S. government backs them. Treasuries can look more appealing in the current high-interest-rate environment than riskier dividend-paying stocks.
For example, a short-term Treasury that pays 4% interest can look far more appealing than a stock that pays a 5% dividend. It’s all about the reduced risk found in Treasuries. Additionally, Treasuries are tax-exempt from state and local income taxes.
Rentals can be either passive or direct. The latter requires the investor to get involved. Many passive strategies can be found in online real estate crowdfunding platforms. There are many different types of crowdfunding platforms. Deals can be structured in debt, equity, or both. The deal structure can determine if investors will receive distributions.
Investors can find deals that suit their interests, including residential, office, industrial, and other categories of real estate.
Income from crowdfunding platforms can come in the form of regular payments and appreciation. Depending on the deal, hold times can be short-term to multi-year. Investors should be aware that trying to exit early from a deal can be costly.
Direct real estate means buying and managing an investment property. This might not be a bad thing for those who are looking for a second venture after selling their business. Also, direct real estate doesn’t mean the investor must spend all their time managing property. Property management companies or employees can help. But this will increase cost, impacting returns.
A 1031 exchange is a great way to defer taxes. When you consider that long-term capital gains rates top out at 20%, the tax bill can be fairly large. But it doesn’t end there. There also might be a Federal depreciation recapture tax of 25% and a potential 3.8% Net Investment Income Tax (NIIT).
The ability to defer all these taxes leaves more principal on the table. For the investor, this is more cash that can be put to work in other investments.
While that cash is working and the replacement property is generating income, that same income has the potential to be sheltered through a revised depreciation schedule.
A 1031 exchange modifies the depreciation schedule of the relinquished property. The new schedule has the potential to better shield income from taxes. There are two depreciation schedule paths with a 1031 exchange — 1) separate depreciation schedules or 2) treat the entire replacement property as a new asset. Trying to figure out which one is more advantageous is best done with an accountant.
There are plenty of options when it comes to finding income-generating strategies to replace your business income. Investors should be aware of the tax implications of any strategy. An account or financial advisor can help guide investors to a strategy that best suits their situation and goals.