InvestHH Archives | Page 5 of 44

Sep

2023

What Happened During Tulip Mania?

By Ashley Kilroy | Growing Wealth, invest, Investing | Comments Off

One of the most famous instances of an asset bubble was the “Tulip Mania” that erupted in Holland during the 17th century. It was the first recorded major financial bubble, during which demand for tulips exploded, and prices for the flowers followed suit.

This led some investors to speculatively purchase tulips, resulting in losses when prices fell back down. Despite Tulip Mania occurring centuries ago, it can still be used as a history lesson for current traders and investors.

What Was Tulip Mania?

Tulip Mania was a speculative frenzy that erupted in Holland during the 17th century. The Dutch were newly independent of Spain and building themselves into prosperous traders. The mid-1600s was a period of wealth for them, as they benefited from rare imports brought through the Dutch East India Company.

Interest in exotic items was at an all-time high, and collectors became fascinated with not just tulips, but “broken” tulips. These tulips came from bulbs and grew into striped or multicolored patterns. As demand grew, more companies began selling bulbs.

The most famous tales about Tulip Mania sound like something out of a book. People of all walks of life bought the flowers in a frenzy at sometimes extremely high prices. They hoped for significant returns and to escape their social classes, but they met financial disaster. Those investors fell into ruin when the tulip bubble burst in 1637 – similar to the dotcom bubble in more recent times – and some of the stories even detail tragic endings; people losing everything and drowning themselves in the canals. All because a tulip-incited mass hysteria that created a financial crisis.

But, is it really true?

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What Really Happened During Tulip Mania?

The “mania” in the story of Tulip Mania comes from an 1841 account by a Scottish author named Charles MacKay. His Memoirs of Extraordinary Popular Delusions and the Madness of Crowds detailed a “tulipomania” where people poured years of salaries into the speculative tulip trade. From farmers, to nobles, to chimney-sweeps, he documented every class buying in. Then, the memoir described mayhem following the market collapse in 1637. Ultimately, MacKay created a dramatic tale that was more fiction than fact.

There was a Dutch tulip bulb market during the Dutch Golden Age. However, traders were limited to buyers with the finances to invest in luxury items. Typically, this group included merchants, artisans, and the upper class.

Additionally, the price increase was not consistent. Between December 1636 and February 1637, some highly sought-after bulbs experienced a price spike. Some of the most expensive went for 5,000 guilders, which equaled the value of a nice home in 1637. Or, there is evidence that the highest bid totaled out to 5,200 guilders. That matched 20 times the yearly salary of a skilled worker. But these prices were the exception, not the rule.

That leaves the final part of the story: the fallout.

Tulip Mania Bubble Burst

Tulip Mania is the classic and most well-known historical example of a financial bubble.

Traders bought into the bulbs with the intent to resell and earn a profit. However, the flowers’ held no inherent value. Their status as a luxury item determined their prices and pushed demand. In fact, demand grew so high that professional traders began bidding on the product on the Stock Exchange of Amsterdam. People even used margined derivative contracts to increase the number of tulips they could buy despite their financial limits.

But before spring even hit, the bubble burst. The mania fell away after the tulips lost their value when the supply of tulips increased due to warmer weather. With so many of the crops, bulb traders realized the product wasn’t as rare as they thought. An auction in Haarlem in February of 1637 seemed to solidify the thought when the auctioneers failed to sell any bulbs.

When the prices dropped, traders had to sell their holdings for a lower value. However, this led to a few broken relationships and lost reputations, not any tragic deaths.

So, there was no morbid end when the Tulip Mania bubble burst. MacKay reported that Holland’s national economy fell apart due to the volatile market crash, but those claims appear exaggerated. The bubble only impacted those who were involved in the Tulip trade, and most investors were in an easily salvageable position. They financially recovered relatively quickly. On the other hand, growers did struggle to replace the lost buyers when certain contracts fell through.

What Tulip Mania Reveals About Financial Markets

While the story is more straightforward than MacKay made many believe, it is still a valuable moment in economic history. It became a parable that explains the nature of bubbles and the crashes that occurred throughout the history of the stock market.

Part of its value as a lesson stems from its moment in time. Multiple bubbles followed Tulip Mania, including the railroad mania bubble during the 1840s, where commentators encouraged investors to buy into U.K. railway stocks or in the early 2000s when Americans began speculating in residential housing before that bubble burst.

The dynamics behind each of these events is similar to the dynamics of the tulip bubble. Speculators drive up the price of an asset beyond its intrinsic value until the bubble eventually busts and those who bought at the top of the market end up losing money in the market downturn.

The Takeaway

Tulip Mania is perhaps the penultimate example of a market bubble, which still resonates today, even though it occurred in Holland centuries ago. Bubbles can also occur in the pricing of individual securities, sectors, or the broader stock market, eventually leading to a crash in prices.

A stock market crash is an alarming time that can send many investors into a panic. They see the drop and move immediately to selling. However, panic selling in the face of market volatility can have disastrous effects on a portfolio. Either you sell when the market is struggling and earn lower returns as a result, or you miss out on the market rebound.

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Sep

2023

How to Invest in Opportunity Zone Funds

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

The Qualified Opportunity Zone program is an initiative aimed at incentivizing investors to allocate cash to economically distressed communities who could benefit from the capital.

The Qualified Opportunity Zone program, highlighted by the Community Development Financial Institutions Fund, was rolled out as part of the 2017 Tax Cuts and Jobs Act. The program allows some U.S. investors to offset capital gains taxes under certain conditions by investing in some communities.

What Is an Opportunity Zone Fund?

Opportunity Zone (OZ) Investment Funds are a type of alternative investment fund that offers capital gains tax relief for some investments aimed at revitalizing communities. Opportunity Zones represent what the Internal Revenue Service calls an “economic development tool,” designed to accelerate economic development and job creation in economically struggling U.S. communities.

The Treasury Department determines eligible Opportunity Zones, of which there are thousands spread across the United States. Corporations or partners establish an Opportunity Zone Fund and use it to invest in properties located in a recognized opportunity zone.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

How to Invest in a Qualified Opportunity Zone Fund

To take advantage of the tax-efficient investment benefits of OZ investing, interested partners must first register as a corporation or partnership, complete IRS form 8996, and file the form along with their federal tax returns. After gaining approval by the IRS, the fund must commit at least 90% of its assets to a specific Opportunity Zone. Once that threshold is cleared, the QOF is eligible for capital gains tax relief.

Qualified Opportunity Fund Investment Requirements

The money that Qualified Funds invest in distressed communities must also fit the Treasury Department’s criteria of an Opportunity Zone investor.

• The Fund must make significant upgrades to the community properties they invest in with fund dollars.

• The investment must be made within 30 months of becoming eligible as a Qualified Opportunity Fund.

• The investment must meet specific Treasury Department financial investment standards. In other words, the investments made in community properties must be equal or superior to the original value paid by the Opportunity Zone investment fund. For instance, if an Opportunity Zone Fund purchased a distressed property for $500,000, that investor has the 30-month window to steer at least $500,000 into the Opportunity Zone property improvements.

• Some Opportunity Zone properties qualify for opportunity funds (private and multi-family homes, business settings and non-profit properties) and some don’t. For example, golf and country clubs, liquor stores, massage parlors, and gambling facilities do not qualify as Opportunity Zone investments.

• The investor must commit to a timely investment in Qualified Opportunity Funds – the longer the time, the bigger the capital gain deferral. The IRS says the tax deferral may last until the exact date on which the Qualified Opportunity Fund is sold or exchanged, or by December 31, 2026. By law, the investor has 180 days from a capital gains sales event to turn those gains into an Opportunity Zone investment.

• The funding program is tiered, with a 10% tax exclusion offered to investors who hold a Qualified Investment Fund investment for at least five years. If the investor holds the investment for seven years, the tax exclusion rises to 15%. If the investor stays in for 10 years or more, the IRS allows for an adjustment based on the amount of the QOF investment based on its fair market value on the exact date the investment is sold or exchanged. Any appreciation in the fund investment isn’t taxed at all, according to the IRS.

• Opportunity Zone investors don’t have to physically reside in the communities they financially support, nor do they have to hold a place of business in that community. The only criteria for eligibility is making a qualified financial investment in an eligible, economically distressed community and the ability to defer the tax on investment gains.

Opportunity Zone Investment Considerations

Investors looking to defer capital gains taxes may view Qualified Opportunity Funds as an attractive proposition. Before signing off on any Opportunity Zone commitments, however, investors may want to review some key facts and investment risks worth keeping in mind when investing in OZs.

Real Estate as an Investment

Since Opportunity Zone funding focuses on distressed communities, most investments are real estate oriented, making it an alternative investment that may be part of a balanced portfolio. Typical Opportunity Zone investments include multi-family housing, apartment buildings, parking garages, small business dwellings/strip malls, and storage sheds, among other structures.

Recognize the Up-Front Cost Realities

Opportunity Zones are a high priority for public policy administrators, which is one reason QOFs require high minimum investments. Up front minimums of $1 million aren’t uncommon with Opportunity Zone Funds, and investors should know that going into any funding situation. In most cases, that means that accredited investors are more likely than other individuals investors to take advantage of OZ investing.

Your Cash May Be Tied up for a Long Time

To optimize the capital gains tax break, Opportunity Zone investors should count on their money being tied up for 10 years. Funds need that time to collect and disseminate cash, choose the appropriate potential properties for investment, and conduct the actual remodeling or upgrades needed to turn those properties into profitable enterprises. Thus, lock-up timetables can go on for a decade or longer.

Management Fees Can Eat into Portfolio Profits

Like any professionally managed financial vehicle, Qualified Opportunity Funds come with investment fees and expenses that can cut into profits. While many investors opt for Opportunity Zone investments for the tax breaks, those investors may also expect their investment to generate healthy returns. To get those returns, they can expect to pay the fees and expenses associated with any professional managed investment fund.

The Takeaway

Investing in Opportunity Zone funds allows some U.S. investors to offset capital gains taxes under certain conditions by investing in some communities. These funds are a type of alternative investment that may be an attractive addition to a portfolio.

Above all else, Opportunity Zone funds come with a healthy measure of risk, including investment risk, liquidity risk, market risk, and business risk. While the promise of a tax break and the opportunity to boost worn-down U.S. communities are appealing, any decision to invest in Opportunity Zones should be made with the consultation of a trusted financial advisor –- ideally one well-versed in tax shelters and real estate investing.

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Sep

2023

How Time-Weighted Rate of Return Measures Your Investment Gains

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

One of the most important and most common methods investors use to measure their returns is the time weighted rate of return formula. That’s because the time-weighted rate of return measures a compound rate of growth.

The time-weighted rate of return incorporates the impact of transactions such as portfolios rebalancing, contributions, and withdrawals. That leaves investors with a clearer picture of their portfolio’s overall performance.

What Is the Time-Weighted Rate of Return?

Starting with the basics, a return on investment (ROI) is a measure of how much money investments earn, or how much they’ve grown in value. Returns can be positive or negative (if a stock loses value following its purchase, for example). But obviously, investors make decisions with the goal of earning positive returns.

A rate of return, then, is a measure of the pace at which investments are accruing value, expressed as a percentage. The higher the rate of return, the better. Essentially, it’s a measure of a portfolio’s or investment’s performance over time. Rates of return can be calculated for certain time periods, such as a month or a year, and can be helpful when comparing different types of investments.

But investment portfolios are rarely static. Many investors make contributions or withdrawals to their portfolios on a regular basis. Many people contribute to their 401(k) with each paycheck, for example, or rebalance when market moves throw their asset allocation out of whack.

During these transactions, investors are buying and selling investments at different prices and times based on their investing strategy. That can make it more difficult and complicated to calculate a portfolio’s overall rate of return.

That’s where the time-weighted rate of return formula becomes useful. In short, the time-weighted rate of return formula takes into account a portfolio’s cash flows, and bakes in their effect on the portfolio’s overall returns. That gives investors a better, more accurate assessment of their portfolio’s performance.

That’s why the time-weighted rate of return calculation is, for many in the financial industry, the standard formula for gauging performance, over both the short- and the long-term.

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The Time-Weighted Rate of Return Formula

The time-weighted rate of return formula can look intimidating for even seasoned investors, but it’s an important step in building and maintaining an investment portfolio. But like many other financial formulas, once the variables are identified, it’s a matter of plug-and-play to run through the calculation.

First, let’s take a look at the basic portfolio return calculation:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value

While this formula provides a value, it assumes that an investor made one investment and simply left their money in-place to grow. But again, investors tend to make numerous investments over several time periods, limiting this calculation’s ability to tell an investor much about their strategy’s effectiveness.

That’s where the time-weighted rate of return comes in. In essence, the time-weighted formula calculates returns for a number of different time periods — usually additional purchases, withdrawals, or sales of the investment.

It then “weights” each time period (assigns them all roughly equal importance, regardless of how much was invested or withdrawn during a given period). Then, the performance of each period is included in the formula to get an overall rate of return for a specified period.

Calculating the time-weighted rate of return over the course of a year, for instance, would include the performance from each individual month. And, yes, that’s a lot of math. Computers and software programs can help, but it’s also doable the old-fashioned way.

This is what the time-weighted rate of return formula looks like:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn)] – 1

There are variables needed to calculate the equation:

n = Number of time periods, or months
RTP = Return for time period (month) = (End value – initial value + cash flow) ÷ (initial value + cash flow)
RTPn = Return for the time period “n”, depending on how many time periods there are

Let’s break it down again, and assume we’re trying to calculate the time-weighted return over three months. That would involve calculating the return for each individual month, three in all. Then, multiplying those returns together — “weighting” them — to arrive at an overall, time-weighted return.

How to Calculate Time-Weighted Rate of Return

To run through an example, assume we want to calculate a three-month, time-weighted return. An investor invests $100 in their portfolio on January 31. On February 15, the portfolio has a value of $102, and the investor makes an additional deposit of $5. At the end of the three-month period on April 30, the portfolio contains $115.

For this calculation, we wouldn’t think of our time periods as merely months. Instead, the time periods would be split in two — one for when a new deposit was made. So, there was the initial $100 deposit that would constitute a time period that ends on February 15. Then a second time period, when the $5 deposit was made, which constitutes a second time period.

With this information, we can make the calculation. That includes calculating the return for each time period during our three-month stretch. So, for time period one, the basic formula looks like this:

Return for time period = (End value – initial value + cash flow) ÷ (initial value + cash flow)

Now, we plug in our variables and calculate. Remember, there was no additional cash flow during this first period, so that won’t be included in this first calculation.

Time period 1:
($102 – $100) ÷ $100 = 0.02, or 2%

Then, do the same to calculate time period two’s return:

Time period 2:
[$115 – ($102 + $5)] ÷ ($102 + $5) = 0.074, or 7.4%

Now, take the returns from these two time periods and use them in the time-weighted rate of return formula:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn) – 1

With the variables — remember to properly use percentages!

TWR = [(1 + 0.02) x (1 + 0.074)] – 1 = 0.95, or 9.5%

So, the time-weighted return over this three-month stretch (which included two time periods for our calculation), is 9.5%. If we had simply done a basic return calculation, we’d reach a different number:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value
$115 – $100 ÷ $100 = 0.15, or 15%

That 15% figure is too high, because it doesn’t account for cash flow. In this case, that was a $5 deposit made in mid-February. The basic return formula folds that into the overall return figure. The time-weighted calculation gives us a more accurate return percentage, and one that accounts for that mid-February deposit.

Other calculations

While the time-weighted rate of return is an important measurement, it’s not the only way to look at a portfolio’s returns. Some investors may also choose to evaluate a portfolio or investment based on its money-weighted rate of return. That calculation is similar to the time-weighted rate of return because it incorporates inflows and outflows, but it does not break the overall investment period into smaller intervals.

Another common measure is the compound annual growth rate, (CAGR), which measures an investment’s annual growth rate over time and does not include the impact of inflows and outflows.

The Takeaway

Having an accurate, timely view of a portfolio’s performance is critical for understanding current investments, planning future investments, and considering changes to your asset allocation. While other rate of return calculations can be useful, it’s important to understand their limitations.

The time-weighted rate of return formula is helpful because it takes into account the numerous inflows and outflows of money over various time periods. Armed with that insight, investors can adjust their strategy to try to increase their rate of return. That may mean reallocating or rebalancing their portfolio to include more aggressive investments or less risky securities.

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Sep

2023

How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

Recommended: What Is a Market Maker?

The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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FAQ

How can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

Photo credit: iStock/DNY59

Sep

2023

What Is Tax Lien Investing?

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Tax lien investing involves an investor buys the claim that a local government makes on a property when an owner fails to pay their property taxes. Each year, states and municipalities sell billions of dollars in tax liens to the public.

The lien itself is a legal claim of ownership that a city or county makes against any property whose owner hasn’t paid taxes. The government then sells those claims, usually at auction, to investors. It is considered an alternative investment and a way to get real estate exposure in a portfolio.

How Tax Lien Investing Works

Tax lien investing involves an investor purchasing a property at auction that currently has a tax lien against it. They pay off the lien, and then the property is theirs, typically purchased as an investment.

If an investor wins a tax lien certificate at auction, they must immediately pay the state or local government the full amount of the lien. Then entitled to collect the property’s tax debt, plus interest and penalty fees. The interest that the property owner must repay the investor varies from state to state, but is usually in the 10%-12% range, using a simple interest formula. Some states charge as much as 2% per month on tax liens.

Property Tax Liens Explained

Between 2009 and 2022, historically low interest rates led many income-oriented investors have started to look more closely into buying tax lien certificates as a way to generate more returns from their portfolios. With relatively high interest rates, tax liens offer one way to generate investment income. Unlike many other interest rates, the rates on property taxes aren’t affected by market fluctuations, or decisions by the Federal Reserve. Instead, state statutes set the interest rates on overdue taxes.

That makes tax liens a potentially attractive alternative investment in a period of rock-bottom interest rates. But they come with their own unique risks. For starters, the investor only realizes the high interest rates if the property owner agrees to pay them.

The fact that the property owner is delinquent on their taxes may indicate, however, that they’re in a bad state financially, and unable to pay back the new owner of the lien. In that case, the only way for an investor to recoup the initial cost of buying the lien, plus interest and penalty fees, is to foreclose on the property and sell it. In that situation, the investor gets the money from the proceeds from the sale.

The good news for tax lien investors is that the lien certificate they receive from the local government usually supersedes other liens on the property, including any mortgages on it. That entitles the tax-lien investors to full proceeds from a foreclosure sale in most cases. The only creditor on a property who may have priority over tax-lien investors is the federal government for liens imposed by the Internal Revenue Service.

The bad news is that the lien certificates don’t, in any circumstances, give the investor ownership of the property. In cases where the property owner doesn’t pay the investor the money owed, a tax-deed foreclosure is the only way an investor can get paid.Those proceedings, along with eviction, repairs and other costs, can cut into returns made by the investor.

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How to Buy Tax Liens

Not every state allows the public auction of overdue property taxes, but thousands of municipalities and counties across the country currently sell tax debt to the public.

For a new investor, one place to start looking into buying tax liens is by getting in touch with your local tax revenue official. They can point you to the publication of overdue taxes. Most states advertise property tax lien sales for before the actual sale. Most of the time, these advertisements let you know the property owner, the legal description of the property, and the amount of delinquent taxes.

How Do Tax Lien Sales Work?

Tax lien sales often, or mostly, happen at auction. The auctions themselves vary by municipality and state. Some are online, and others are in person. Some operate by having the investors bid on the interest rate. In this auction format, the municipality sets a maximum interest rate, and the investors then offer lower interest rates, with the lowest bidder winning the auction.

In another popular auction format, investors bid up a premium they’re willing to pay on the lien. In this format, the bidder who’s willing to pay the most — above and beyond the value of the lien — wins. But the investor can also collect interest on that premium in many cases.

If that sounds like too much work and research, investors can access this unique asset class by purchasing shares in a tax lien fund run by an institutional investor. Institutional investors may have the research, focus, and experience new investors may not have, or want to develop. Professional investors also have experience with some of the litigation and other expensive pitfalls that can come with a property foreclosure.

Tax Lien Investing Risks

As a financial asset, tax liens offer a unique opportunity for income, but they also have their own set of risks. The first is the property itself. The neighborhood and condition of the property make a difference in the value of the property and the ease with which an investor can sell it.

Another investment risk to keep in mind is that some owners may never pay back the property taxes they owe, and if the value of the property, after foreclosure, may not pay back the money invested in the lien. Investors also may have to deal with a property embroiled in litigation, or on which other creditors have a claim. This is one area where research can make a big difference.

Also, liens don’t last forever. They come with expiration dates, after which the owner can no longer foreclose on the property or collect overdue taxes and interest from the property owner. In some cases, investors will pay taxes on the property to which they own the lien for years, just to keep a claim on the underlying property. This can be a smart strategy if it gets the investor the property at a lower price, but it can also create opportunity costs.

Finally, the overall returns on tax liens are going down in many cases, as more large institutional investors start bidding on tax lien auctions. More bidders drive down the interest rates or drive up the premiums, depending on the auction format.

Benefits to Investing in Tax Liens

Investing in tax liens also has its potential benefits, including the chance of generating outsized returns (but keep the risks in mind, too). Sometimes, properties can be purchased for a relative bargain — such as a few hundred or a few thousand dollars, which can obviously be attractive to investors, though it may not be typical. Tax lien investing is another way to diversify a portfolio as well.

The Takeaway

Tax lien investing involves buying the claim that a local government makes on a property when an owner fails to pay their property taxes. Once an investor buys that claim, they then pay off the back taxes, and take ownership of the property. Each year, states and municipalities sell billions of dollars in tax liens to the public, making for ample opportunity.

Tax lien investment can offer an alternative investment that balances out a diversified portfolio, but it has many risks that individual investors should understand. Of course, there are plenty of other ways that investors can put their money to work for them.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How can you get started in tax lien investing?

Prospective tax lien investors can get in touch with local tax officials to learn more about tax liens in their area, or do some internet searches to find when and where auctions are taking place. They can then bid and potentially win a claim on a property.

What’s the difference between tax liens and mortgage liens?

Tax liens are placed on a property by the government for unpaid property taxes, whereas a mortgage lien is placed on a property by a lender in order to secure it for a borrower failing to pay their home loan.

Are IRS tax liens public record?

IRS tax liens are federal tax liens, and are public record. The IRS will file a public document to alert others in the even that a federal lien is being placed on your property.

Photo credit: iStock/nortonrsx

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