A Beginner’s Guide to Tax Lien Investing

A “How To” Guide for Investing in Tax Liens

By Susan Lassiter-Lyons | Real Estate

May 29

If you’ve been doing some homework on alternative investments, you may have already come across tax liens, a form of investment which offers you the opportunity to make returns, often somewhere in the ballpark of 10 to 18 percent.

Who would have thought you could make money from something that contains the dreaded “t” word?

Tax lien investing is a legitimate way to make a predictable return for your money, but like any investment, you should be aware of the risks and potential pitfalls first. Here’s the rundown on what you should expect and what you need to know before investing:

What is a tax lien?

A tax lien is placed either by the federal government, state government or local municipalities as a claim on privately-owned property. The lien is usually placed on the property when the owner fails to pay their property taxes (or other taxes) and gives the authority that places it the first right to the property over other creditors.

Overall, this is not good news for the property owner if they are in a tax lien situation. Their credit record will also be blemished by it so it’s always preferable that they pay the money owed sooner rather than later.

So, where do you come in as an investor? Those local municipalities would much prefer that they had the cash flow to keep running their operations, so several states allow for the sale of those tax liens to investors. The liens may run from being quite small (say, $100) to several thousand dollars, depending on the property and state of delinquency.

NOTE: Tax liens aren’t to be confused with tax deeds as the two work differently. In a state which sells tax deeds, you are actually purchasing the deed to the delinquent property and will hold it free and clear without a redemption period.

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How does a tax lien investment work?

As an investor, you purchase a tax lien certificate that acts as a claim against the property in question. These are usually sold at auction and the bidder who wins is the one who bids the lowest interest rate that they are willing to receive and comes in lower than other bidders.

Once you hold the certificate, you now have the right to collect the unpaid taxes, a penalty, and interest on the late payment. The interest usually runs between 8% and 36%, depending on the laws of the particular jurisdiction. The property owner now must pay you within the redemption period of the lien, which can be mere days to five years, depending on the area.

As an investor, you purchase a tax lien certificate that acts as a claim against the property in question. These are usually sold at auction and the bidder who wins is the one who bids the lowest interest rate that they are willing to receive and comes in lower than other bidders.

Once you hold the certificate, you now have the right to collect the unpaid taxes, a penalty, and interest on the late payment. The interest usually runs between 8% and 36%, depending on the laws of the particular jurisdiction. The property owner now must pay you within the redemption period of the lien, which can be mere days to five years, depending on the area.

Know the redemption period for your tax lien investment - how long can you tie up your cash? Click To Tweet

The obvious next question then is, what happens if the property owner doesn’t pay up? As the lienholder, you can ultimately take the deed to the property. One thing to be monitoring over this period is whether any new liens are issued against the same property. You will want to bid on those too because newer liens take precedence.

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From this, you can gather that it’s better if you have cash available which you’re not anticipating needing in a hurry. If you get a lien with a longer redemption period, you are potentially waiting years for any sort of return. You could say this is a con of this type of investing – you only cash in at the end of the redemption period and, in the meantime, don’t receive income on your money.

What are the risks of tax liens?

Like any other investment, there are risks involved with tax lien investing, although it does tend to be a lower risk category than say, the stock market. One reason for this is that the investment is tied to a property asset, so if you’re not paid for the lien, you can take the title of the property.

Here are the risks to be aware of:

  • Each state has different rules regarding interest rates, redemption periods and pre-foreclosure requirements. This can become confusing for investors if you’re looking at spreading across different states.
  • States with pre-foreclosure conditions require lien-holders to follow them to the letter. If something is left out, you risk your lien being declared invalid.
  • In most cases, you won’t know the true state of the property. You may find yourself with the deed to a complete disaster. It always pays to do your due diligence – investigate the property where you can and at least be sure that you can sell it for more than your lien is worth. Investors have used liens to snap up properties for pennies on the dollar, but there’s also the argument that you will probably need to spend money and effort on the property before selling it. Many investors prefer to stick to areas that they are familiar with for this reason.
  • Following on from above, you also run the risk of landing a property that isn’t useable. What if you end up with an acre of marshland? This is again, a case for doing your homework first. Several years of unpaid taxes may indicate the property is not a good investment
  • There may be other past-due taxes associated with the property which you will have to take on in a foreclosure situation. For example, city, county or school board taxes.
  • The owner may file for bankruptcy, putting property taxes on hold. There have been situations where this has happened immediately prior to the property going up for lien auction, before the tax authority is informed of the bankruptcy status. The tax lien ends up being sold at auction, but the sale is invalid. The purchaser can get their money back, but there is no return (and there’s bound to be a wait period to get your payment).
  • If you take on a lien with a longer redemption period (say, a year or more), new lots of taxes will fall due. You will need to pay these in order to remain the priority lien holder, otherwise, liens may be subsequently sold for those taxes. This means that you need to keep up your diligence over the redemption period. Many investors hire lawyers to take care of the details such as additional taxes or foreclosure proceedings (another cost to factor in if you take this route).
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Why invest in tax liens?

One of the advantages of investing in tax liens is that you can potentially get in with a much lower capital investment than some other choices. Depending on the lien amount, you might be able to get in for a couple of hundred dollars or less.

Secondly, if you’ve done your homework and managed to avoid any of the pitfalls listed above, you can find yourself with a relatively low-risk investment which brings you a predictable return. When compared to something like flipping property, tax liens are much more stable because there isn’t the same volatility as the property market.

How can investors get started?

Tax liens are generally sold at auction by the county or municipality concerned. You might want to start with an area that you already know well, as it will make it easier for you to do your homework before the sale.

A simple Google search of “(your county or municipality) tax lien sales” will usually turn up website information, but you should also check local newspapers. The county is required to post public notices of tax lien auctions. If all else fails, just call them and ask for details of their next tax lien auction.

You can expect there to be some stiff competition from other investors and even large lien investment funds. Remember, auctions are designed to promote a competitive environment which nets the seller the best possible deal. Know your true minimum rate for a property and don’t get caught up in auction fever to go any lower.

Parting thoughts

While you can get into tax lien investing for a relatively low amount and it is lower risk in the scheme of investments, beware of the possible pitfalls first.

It’s always important to do your research on the property and understand whether you’ll be getting yourself into a bad deal should the deed end up in your possession. You ideally want something which you’ll be able to sell with little trouble.

In most cases, rather than end up with the property you’ll simply have your return on investment after the redemption period. This is a nice, predictable income, although you need to be prepared to wait for it if you’re in on a longer redemption period. Know the rules for the respective jurisdictions that are selling and choose those with terms which suit your preferred period for tying up your cash.

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