Tax deed properties: What they are and how to invest

Feeling sticker shock every time you shop for a home? You’re not alone. It’s natural to ask yourself if there’s a way to invest in a property without breaking the bank. The answer, for many, is to pursue a tax deed property. These are homes that have been foreclosed on by local governments, due to their owners failing to pay property taxes and sold at a public auction – often for a fraction of their market value – to help the government recoup some of the debt owed. If you win the auction bid you could buy a property for a lot less than what you might have paid on the open market.

Buying a tax deed property can be a smart way to get an asset you can flip, rent out, or enjoy as a first-time home buyer. Like any investment, these properties have their advantages and disadvantages. Let’s take a closer look at tax deed properties, the steps involved with buying one, associated expenses, pros and cons, and more.

What is a tax deed?

A tax deed is a legal document that gives ownership of a property to a local government or another entity after the property has been foreclosed on due to unpaid property taxes.

Normally, homeowners pay property taxes annually or monthly through their mortgage payment. However, if those payments lapse, the property could be foreclosed on. The local government holds a public auction, called a tax auction or tax foreclosure sale, in which anyone can bid on the property. The winner of the auction is then granted the deed to the property.

What is the difference between a tax lien and a tax deed?

A tax deed is a transfer of ownership after foreclosure due to unpaid property taxes. The owner has lost their deed to the property, except for a possible redemption period, depending on state law.

A tax lien, on the other hand, is a financial claim against a property made by the local government because property taxes have gone unpaid. A tax lien doesn’t transfer ownership of the property, but it stops the owner from selling or refinancing the property until the lien is cleared.

Like tax deeds, tax liens can be auctioned off. Buyers purchase certificates that represent debt owed. They earn interest on the debt, and if the property owner doesn’t pay back the lien, with interest, within a certain time, the tax lien holder can begin foreclosure proceedings to take the property.

In a tax deed auction, you are purchasing the property outright, subject, of course, to any redemption period or title defects.

Here’s a table that highlights the differences between a tax deed and a tax lien:

How buying at a tax deed sale works

It’s important to do your homework about tax deed sales, as the process varies from state to state. But there are some general and common procedures you can count on, regardless of your location. When a homeowner fails to pay their property taxes, they may face legal action and foreclosure. Generally, it usually takes more than 1 year of missed property taxes to trigger major legal action. The homeowner is also given ample notice of the dangers of unpaid property taxes. Further, they are given time to pay the back taxes, usually with interest and penalties, before the property is foreclosed upon or auctioned off.

Here’s a list of common steps you can expect:

1. The local government applies for the tax deed. This gives the government permission to sell the property at auction.
2. The government notifies the property owner. This is done by mail, posting a notice on the property, and/or placing a notice in the newspaper.
3. The property is offered at a public auction. There is a minimum bid amount that reflects the owed taxes, penalties, and other costs.
4. Auction attendees bid on the property. Auctions are either online or in-person, with the tax deed going to the highest bidder.
5. The winning bidder pays for the property. Typically, there is a deadline of a few days to a few weeks after the auction.
6. A redemption period ensues. Once the property is sold at auction and the tax deed is issued to the winning bidder, the former property owner often (depending on state rules) has a certain amount of time to redeem their property by paying off the taxes and penalties.
7. The former property owner receives any excess money. The difference between the bid and what was owed for back taxes goes back to the former owner.

Redemption periods explained

In many states, the former owner of a property that has fallen victim to a tax deed auction is given what’s called a redemption period. This is a set amount of time they have to pay back taxes, interest, and penalties to get their property back.

The redemption period can complicate the purchasing process, and the deadline can vary, depending on state laws, so it’s a good idea to carefully research the laws in the state where you are considering a tax deed sale. You can also reach out to a real estate attorney for more guidance. Here are a few examples:

• Georgia: Former property owners have 1 year from the time of the tax deed sale to reclaim their property by paying off their debt.
• Hawaii: Former property owners have 1 year to reclaim their property by paying off their debt.
• Tennessee: Unless this right is expressly waived, former owners have 2 years to redeem their property.

How to invest in a tax deed property

Buying a tax deed property can be more complicated and risky than purchasing real estate the traditional way. Yet it can be a worthwhile strategy if you want to diversify your portfolio and claim a better deal overall. Here are the general steps to follow:

1. Locate county tax deed sales. Check county tax authority websites or reach out to local clerks to find upcoming sale lists.
2. Attend and bid on a property. Get pre-registered, inspect the property, if possible, set a firm maximum bid, and stay disciplined.
3. Pay for the property. Have your funds ready. Most auctions require cashier’s checks or wire transfers within days of you placing a winning bid.
4. Decide what to do after winning. Once you win a property, you’ll need to decide which is best for your goals. There are generally three options:

a. Use as rental property: Hold it long-term for cash flow.

• Pros: Steady income, tax deductions, and potential appreciation.
• Cons: You are now a property manager with maintenance obligations.

b. Sell as is: Ideal if you want to go for a quick profit.

• Pros: Fast sale with minimal work.
• Cons: If you misjudge what the property is worth, you could lose money.

c. Flip and sell: Renovate quickly a  list with an agent.

• Pros: Relatively quick return on your investment.
• Cons: If you run into surprises, renovations may cost more than expected.

Expenses to expect after a tax deed sale

Additionally, there are legal and financial costs you should prepare for beyond the sale price of the tax deed property.

Here’s a list of some of these common expenses:

• Quiet title proceedings. This is a lawsuit you file to create a court proceeding that clears liens, name errors, or ownership disputes. You receive an official, court-enforced clear title, but you’ll likely pay lawyer fees, as well as court fees, and it can be lengthy.
• Title certification. A title company reviews and researches public records for liens. This is typically fast, easy, and often less expensive than a court action. But it might not clear all defects, depending on the title company’s thoroughness.
• Real estate attorney fees. Whichever option above that you choose, you’ll likely need a real estate attorney, or you can choose a title specialist or escrow company. While they add costs to your budget, it’s essential to get a clean title, especially if you plan to sell the property as is at any time.
• Escrow servicing fees. These fees cover a third party to manage funds and documents, ensuring all sale conditions are met before money is released. This provides financial security for both the buyer and the seller.
• Closing costs. These expenses encompass deed recording, transfer taxes, title fees, and notary fees necessary to finalize the transaction. You should budget for these to ensure the title is legally and officially registered in your name.
• Repairs and maintenance. Tax deed properties are often neglected, so you must budget for structural repairs, trash removal, and securing the building. It’s important to address these immediately, as it’s essential to meet local building codes and prevent further deterioration.
• Real estate agent fees. If you intend to sell or lease the property, you will probably pay commissions or listing fees to a real estate agent. Professional representation helps navigate the market and find qualified buyers or tenants

An example

Let's say you attend a tax deed auction and place a winning bid of $30,000 on a property you later plan to sell. Here’s how the numbers might look in a simplified example:

Keep in mind that this is a hypothetical example that doesn’t account for important expenses like real estate agent commissions, closing costs, repairs, maintenance, or holding costs. In reality, tax deed sales can involve risks such as title issues, competing liens, or challenges in reselling.

Pros and cons of buying a tax lien

When you buy a tax lien, you’re not purchasing real estate. Instead, you’re buying the right to collect the back property taxes owed by the property’s owner, plus interest. Basically, you're giving the government the funds to cover the property taxes, so now the taxes are owed to you instead. Sounds good, right? Well, there are some benefits, but also some drawbacks.

Pros

• Low initial cost: Tax liens are often only hundreds of dollars, a relatively manageable expense.
• Potentially high interest rate: States set the interest you can charge, but often it can be high; some states have 24% interest rates or even higher.
• Passive income: Since you don’t own the property, there is no maintenance or cost.

Cons

• Foreclosure: If the owner doesn’t pay you, to secure the property and profit from it you’ll need to initiate foreclosure proceedings, which can be lengthy and expensive.
• No asset: Unless and until you complete a successful foreclosure, tax liens are not a tangible asset.
• No guaranteed profits: If the owner doesn’t pay you or claims bankruptcy, other entities, like mortgage lenders, might be ahead of you in line to be repaid.

The bottom line: A tax deed sale can quickly earn you profits

Eager to invest in real estate but can’t swing the high price tag of purchasing property on the open market? A tax deed auction could be just the ticket, as these properties are often sold below market value at auction. Just be aware that tax deed properties are commonly neglected and may have lien and title issues. That’s why it’s crucial to thoroughly research auction rules, target markets, and potential risks, as well as budget for any unforeseen obstacles before bidding on a property.

When you are ready to begin this homebuying journey, you can consider applying for a loan with Rocket Mortgage.