Tax lien investing can expose your portfolio to real estate, all without actually having to own real estate. However, experts say the process is complicated and warn that novice investors can easily get burned. Here’s everything you need to know about investing in a tax lien certificate, including how it works and the risks associated with it.
What is a tax lien?
A tax lien is a legal claim that a local or municipal government places on an individual’s property when the owner has failed to pay a property tax debt. The notice usually precedes more serious actions, such as a tax levy, where the Internal Revenue Service (IRS) or local or municipal governments can actually seize a person’s property to recover the debt.
What are tax lien certificates?
A tax lien certificate is created when a property owner has not paid their taxes and the local government issues a tax lien. The certificate lists the taxes owed and any interest and penalties. Tax lien certificates are typically auctioned to investors looking to make a profit.
How investing with tax law works
To recover the back tax money, municipalities can then sell the tax lien certificate to private investors, who provide the tax bill in exchange for the right to collect that money, plus interest, from property owners when they eventually pay off their balance. .
Currently, 29 states plus Washington DC allow the transfer or assignment of delinquent property tax liens to the private sector, according to the National Tax Lien Association, a nonprofit organization that represents governments, institutional tax lien investors and service providers. Here’s what the process looks like.
1. Investors must bid for the tax lien at auction
Tax lien investors must bid for the certificate at auction, and how that process works depends on the specific municipality. Potential investors should start by familiarizing themselves with the local area, advises the National Tax Lien Association. Contact tax officials in your area to inquire how these delinquent taxes will be collected.
Auctions can take place online or in person. Sometimes winning bids go to the investor willing to pay the lowest interest rate, in a manner known as “lowering the interest rate.” The municipality sets a maximum rate and the bidder who offers the lowest interest rate below that maximum wins the auction. However, keep in mind that as interest rates fall, so do profits.
Other winning bids go to those who pay the highest cash amount, or premium, above the lien amount.
2. The winning bidder pays the balance and completes the foreclosure procedure
What happens next for investors is not something that happens on a stock exchange. The winning bidder must pay the full tax bill, including delinquent debt, interest and penalties. Then the investor must wait for the property owners to pay back their full balance, unless they don’t.
Most homeowners have what is called a “repayment period” (usually one to three years) before they have to pay the taxes plus interest in full. But if the homeowner fails to repay the tax debt, the tax lien investor is the one responsible for initiating the foreclosure process, which could allow the investor to take ownership of the property.
If you win a lien at auction, you also need to learn your responsibilities. In Illinois, for example, within four months of purchasing a lien, you must notify property owners that you own the lien and that you can foreclose if they don’t pay back, says Joanne Musa, a tax lien investment advisor and founder of TaxLienLady .com. Then another letter must be sent before the end of the redemption period.
Benefits and Risks of Investing in Tax Liens
Experts recommend thinking carefully about the risks before investing in tax liens. While some investors may be rewarded, others may get caught in the crossfire of complicated regulations and loopholes, which can lead to significant losses in the worst circumstances.
1. Tax liens can be a higher return investment, but not always
From a purely profit perspective, most investors make their money based on the tax lien interest rate. Interest rates vary depending on the jurisdiction or state. For example, the maximum statutory interest rate is 16 percent in Arizona and 18 percent in Florida, while the rate in Alabama is set at 12 percent, according to the National Tax Lien Association.
However, winnings do not always amount to such high yields during the bidding process. Ultimately, most tax liens purchased at auction are sold nationally at rates between 3 and 7 percent, said Brad Westover, executive director of the National Tax Lien Association.
Before he retired, Richard Rampell, former CEO of Rampell & Rampell, an accounting firm in Palm Beach, Florida, experienced this firsthand. Rampell was part of a small group investing in local tax liens in the late 1990s and early 2000s. Initially, the partners did well. But then big institutional investors, including banks, hedge funds and pension funds, chased those higher returns at auctions across the country. The larger investors helped lower interest rates, so Rampell’s group no longer made significant money on liens.
“In the end we didn’t do much better than a CD,” he says. “For the amount of work it wasn’t worth it.”
2. Tax liens have an expiration date
If the property owner fails to pay the property taxes at the end of the repayment period, the lien holder can initiate foreclosure proceedings to take ownership of the property. But that rarely happens: taxes are generally paid before the redemption date. Liens are also the first in line for repayment, even before mortgages.
Still, tax liens have an expiration date, and a lien holder’s right to seize the property or collect on its investment expires at the same time as the lien.
After you purchase a lien, you may also want to pay taxes on the property in subsequent years so that no one else can purchase a lien and thus have a claim on the property.
“Sometimes it’s six months after the redemption period,” says Musa. “Don’t think you can just buy and forget about it.”
3. Investing with tax law requires thorough research
Above all, individual investors considering tax lien investments should do their homework. Experts recommend avoiding properties with environmental damage, such as a site where a gas station has dumped hazardous materials. One reason for this: In the event of foreclosure, the property would be yours.
“You really have to understand what you’re buying,” says Richard Zimmerman, a partner at Berdon LLP, an accounting firm in New York City. “Be aware of what the property is, the neighborhood and the values so you don’t buy a lien that you can’t collect on.”
Potential investors should also review the property and any liens thereon, as well as the recent tax sales and sales prices of comparable properties. If a property has other liens, that can make it more difficult to obtain title in the event of foreclosure.
However, keep in mind that the information you find may often be out of date.
“People get a list of properties and do their due diligence weeks before a sale,” Musa says. “Half of the properties on the list could disappear because the taxes are paid. You’re wasting your time. The closer to the date you do your due diligence, the better. You need an updated list.”
In short
Because investing in tax liens involves so much due diligence, it may be worthwhile to invest passively through an institutional investor who is a member of the National Tax Lien Association. Westover says 80 percent of tax lien certificates are sold to NTLA members, and the agency can often match NTLA members with the right institutional investors. That can make managing the process easier, especially for a beginner.
While tax lien investments can provide generous returns, be sure to consider the fine print, details, and rules.
“I’ve had a few clients and friends who have invested extensively in tax liens, almost as a business, and have done well,” says Martin Cass, regional director of private client services at BDO USA, an accounting firm in West Palm Beach, Florida . “But it’s complicated. You have to understand the details.”
— Bank interest Brian Baker contributed to an update to this story.
