Tax Lien Investing: A Beginner’s Guide to Profiting from Property Tax Liens
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Summary:
Investing in tax liens is an opportunity for retail investors to buy debt from someone else (in the form of a tax lien certificate) and make a return. Tax lien certificates can return money in the form of interest and can also be monetized by foreclosing on the underlying property. Tax lien investing does come with risks, however, so it’s important to understand the basics of how they work and how to invest in them.
Many of us are familiar with the 2008 financial crisis and the mortgage-backed securities that became toxic once the property market faltered and subprime loans defaulted. But did you ever ask yourself why exactly banks were buying mortgages in the first place? The reason is that one person’s debt is another person’s asset. It’s possible to buy debt, meaning the debtor must pay you rather than the initial issuer of the debt.
Buying debt and turning it into an asset that produces returns can be a lucrative investment but it also comes with risks. Although it’s difficult for your average Joe to buy mortgage debt, there is another form of debt they can buy as an investment: tax liens. Keep reading to learn how they work.
What is a tax lien?
A tax lien is a legal claim against a person’s property filed by a government or municipality for unpaid taxes, such as delinquent property taxes. Tax liens are the first step in the process of the government taking harsher action, such as a tax levy in which property can legally be seized in lieu of debt payment.
When a person fails to pay their taxes to either the IRS or a state/county, the IRS will issue a tax lien, which effectively freezes the property. The unpaid taxes could be property taxes, federal income taxes, or various other required taxes. But in most cases, a tax lien is issued on real property for unpaid property taxes. With a lien on it, the property cannot be refinanced or sold.
What is tax lien investing?
Tax lien investing is similar to tax deed investing — in both cases, you invest in debt. However, with tax deed investing, the actual ownership of the property (the deed) is purchased, and the debt needs to be paid. With tax lien investing, you only buy the certificate of debt rather than the property title or deed.
Tax lien certificates as an investment
The property cannot be sold or refinanced to withdraw equity when the government puts a lien against it. Once the government issues the tax lien, it will also issue a tax lien certificate. This certificate shows who owes the money, how much they owe if it’s for unpaid property taxes (or possibly something else), as well as penalties and interest. Once this certificate is issued, it now becomes a security and tradable asset, which the government will auction to private investors.
Pro Tip
From the government’s perspective, they are able to recoup some of the tax debt from the sale more quickly. Tax lien certificates can be sold as investments in 28 states.
From the investor’s perspective, buying a tax lien certificate as a security can produce returns. However, it’s important to note that when buying debt as an investment, the value of the investment depends on the debtor’s ability to pay the debt back and whether the debt is securitized or not. The underlying asset is usually a property, so the tax lien certificate holder must be confident they can sell the property should they need to foreclose.
How do you make money off a tax lien?
When the government auctions a tax lien certificate, the investor immediately pays the amount of the lien. In most cases, the tax lien issuer (government) will collect the principal and interest owed by the debtor and then pay the holder of the lien certificate (investor).
The debtor (property owner) must now pay back the entire lien amount, principal, and interest. If a premium was attached to the price of the tax lien certificate, then the debtor is also on the hook for the premium. The lien certificate will also give a time frame for when the investor needs to be paid back in full, which could be six months to 3 years.
The amount of interest varies from state to state, but it typically can be anywhere from 9%-16%. The payment is just a fixed payment at any time within three years and is not given to the investor on an annualized basis.
The investor can now make money in two ways:
1. They earn interest off the tax lien
2. They take control of the property through the foreclosure process
The second case, in which the investor is able to take over property, is rare, but it can happen. Most investors are looking for tax liens to act as an income-producing asset rather than an opportunity to take over a home for almost nothing. In the case of interest payments, this differs from state to state. In Florida, the maximum interest rate for tax liens is 18%, whereas in Colorado it’s 9% + the Fed’s base rate.
What to look for in a tax lien certificate
A tax lien certificate typically contains the following information. We give the state of Kentucky as an example:
Type: Tax Lien Certificate
Bidding process: Premium
Frequency: Annually, in spring
Interest rate/penalty: Fed rate + 95 or 12%
Redemption period: 3 years
Online auction: Yes
Over the counter: Yes
Bidding process: Premium
Frequency: Annually, in spring
Interest rate/penalty: Fed rate + 95 or 12%
Redemption period: 3 years
Online auction: Yes
Over the counter: Yes
Type
In most cases, you will be buying a tax lien certificate. However, double-check, as there are other securities related to unpaid taxes liens such as a redeemable deed.
Bidding process
There can be a bidding war when tax liens are sold at auction. You need to know what you are bidding against. In some cases, people will bid on the premium (the price of the tax lien certificate); in other cases, people will bid down the interest rate. For instance, in a premium bidding process, the auction might start at $100, with the final winning bid being $150. With interest rate bidding, the certificate might be producing 11%, and the winning bid is 9%.
Certificate auction times
Most governments and municipalities will have a certain time of year when they issue tax lien certificates. For instance, they could hold auctions in Q3, or it could be the “Spring.” It’s best to speak with your local government tax office for auction times.
Interest rate
This is the interest rate the tax lien provides. It can be a fixed rate or it can be linked to the Fed’s base rate. Typical interest rates for tax lien certificates can span from 2%-18%.
Redemption period
This is how long the tax lien investment lasts. Many states will have a three-year window for the redemption period, but in some cases, it can be as low as six months.
Auction style
Some can be in-person auctions, and some can be online auctions. Online auctions can be a great tool if you are looking for tax liens in other states that pay higher interest rates.
Step-by-step process to invest in tax liens
1. Do your due diligence
Now you know what you need to look for: who pays the highest interest rates, the area where the tax lien certificate was issued, and the redemption/premium terms and bidding process.
2. Enter a tax lien auction
You need to find out the time and location of the auction. If you are looking for somewhere close to where you live, you might want to consider calling your local tax office. If you want to invest elsewhere, you might want to do some research online and then follow up by phone if you don’t fully understand the process.
3. Win the bid on a tax lien certificate
Now that you have won the bid, you are officially a tax lien investor and can await your return. Remember, most of the time, the debtor will still pay the tax lien issuer and not yourself.
4. Monitor the investment
In some areas, the investment is not completely passive, and you are required to notify the property owner (the debtor) with a certified letter.
5. Collect your principal return
You can now collect your principal + interest, so you can make a return on your investment. Or…
6. Foreclosure
If the property owner fails to pay off their lien, you now have the right to foreclose on the property. In fact, in some states, there are expiration dates in which you must initiate foreclosure or lose out on the ability to keep your investments. This is quite rare, though.
Risks with tax liens
Yes, returns from tax liens can be pretty good, but there are risks. You should prepare yourself for the following downsides:
The property behind the lien is in horrible condition
If you invest in a tax lien certificate backed by a property that’s in poor condition, this could turn out to be a bad choice. “It is important to keep in mind that there are also risks associated with investing in tax liens, such as the possibility of not recovering the full amount due if the property is sold off at auction,” says Shaun Martin, real estate investor and owner of We Buy Denver Homes.
Even if you foreclose eventually, you might need to put in a bunch of capital to be able to resell it.
You vs. institutional investors
Just like institutional investors have been buying up real estate post-2008 financial crisis, they are also in the tax lien market. This can make it difficult to get tax liens that pay decent rates, as you are a David bidding against a Goliath.
Deadlines and redemptions
Unlike passive investing, where you sit back and collect your money, you need to take action during certain deadlines to collect your money. Tax lien investing work is not hard, but it’s harder than collecting passive income.
Is tax lien investing common?
We wouldn’t be surprised if you have never heard of tax liens as an investment possibility. However, it’s much more common than you think. Rinal Patel, co-founder of real estate investment company We Buy Philly Home, recommends investing in tax liens. “There are lots of benefits, such as high returns and a relatively low barrier to entry, and earning interest rates that are often higher than those offered by other fixed-income investments, such as bonds or certificates of deposit,” she says. “It offers opportunities for small investors to participate in real estate investing without requiring large sums of capital.”
(Tax lien investing) offers opportunities for small investors to participate in real estate investing without requiring large sums of capital. - Rinal Patel, co-founder of We Buy Philly HomeClick to Tweet
There are also several places to go for information on tax lien investing, including recent changes in regulation. The National Tax Lien Association has an online portal with plenty of information on tax lien investing, including paid membership opportunities.
Before you jump into a new investment, you might want to review your financial picture with an investment advisor. Here are some to consider.
FAQ
What are the risks associated with tax lien investing?
The primary risk associated with tax lien investing is having to foreclose on a property, which is in bad condition or cannot be sold for much at auction. There are also risks if you can’t keep up with actively submitting paperwork for payments related to a delinquent tax lien certificate.
How do I find tax lien investment opportunities?
If you are looking in your area, call the local government office that handles tax collection and ask about their tax lien sales, including the timing of sales.
Key takeaways
- Investing in tax liens is an opportunity for your average retail investor to buy debt from someone else (in the form of a tax lien certificate) and make a return.
- Tax lien certificates are issued from governments or municipalities for unpaid taxes. They freeze the debtor’s property and issue a tax lien certificate that can be auctioned to investors.
- Investors in tax lien certificates are paid an interest rate on the debt. If the debtor fails to pay the money, investors can begin the foreclosure process.
- Tax liens can be good investments and have low entry points. But do your homework. If you end up having to foreclose on the property, it could cause more trouble than it’s worth.
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