Tax lien investing is when 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 between $3 and $5 billion dollars in tax liens to the public, according to the National Tax Lien Association (NTLA).
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
Once 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.
Given the historically low interest rates, many income-oriented investors have started to look more closely into buying tax lien certificates as a way to earn more interest on their investments. 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.
How to Buy Tax Liens
Not every state allows the public auction of overdue property taxes, but many do. According to recent estimates by the NTLA, 2,500 municipalities and counties currently sell tax debt to the public.
For a new investor, one place to start is where you live, 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.
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. In both cases, returns are lower than historical averages.
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.
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