Tax deed vs. tax lien: Key differences

Property taxes are an unavoidable cost of owning a home. Failure to pay property taxes can lead to a tax lien on your property or a tax deed sale, both of which are significant problems for the homeowner. For real estate investors, however, tax deeds and tax liens present an opportunity to make money, so it’s important to understand how they work.

What is a tax deed?

A tax deed transfers legal ownership of a property with unpaid taxes to a government body or third party.

Homeowners must pay property taxes, which fund services like schools, libraries, water and sewer systems. If a homeowner fails to pay their taxes, the local government can foreclose on the home and auction it off to recover the taxes owed.

Local governments receive a tax deed when the home goes into foreclosure, transferring ownership to the government. They then use a tax deed sale to sell the home to a new owner.

Tax deed sale process

While the precise steps and process vary from state to state, a tax deed sale roughly follows these steps:

1. The government issues a tax deed to take possession of a home with unpaid property taxes.

2. The government schedules an auction and sets a minimum bid price.

3. Those interested in buying the home at auction can bid on it. The winning bidders become the new legal owner of the home.

            a. A process called redemption allows the owner to reclaim the                                property by paying the overdue taxes.

4. If the highest bidder pays more than the amount of taxes owed, the previous homeowner may be able to ask the government to pay them any excess amount. This only happens upon request, and the time limit for making this request varies by state.

What is a tax lien?

A government entity that is owed unpaid taxes will place a tax lien on the home. The lien is a public record of the debt and makes it difficult for the owner to refinance or sell their home. The owner must pay the tax bill to remove the lien. Tax liens don’t immediately lead to foreclosure.

A tax lien certificate is a financial document that local governments can sell at auction. They assign the buyer the right to collect the unpaid taxes, plus interest and fees. Usually, the buyer of the certificate pays the government the taxes owed, meaning the tax lien investor’s potential profit comes from the interest and fees owed.

Tax lien sale process

A tax lien sale usually happens before a home enters foreclosure due to unpaid taxes. This is the typical process followed:

1. The government places a tax lien on the home and makes the tax lien certificate.
2. The government auctions the certificate to investors.
3. The highest bidding investor receives the tax lien certificate and pays the owed taxes plus other costs to the government.
4. The investor pursues the homeowner for payment of the taxes owed, plus interest and penalties.
5. If the homeowner still does not pay the taxes owed, the highest bidder can begin the process of foreclosing on the home.

Tax lien vs. tax deed: A comparison

Tax deeds and tax liens both relate to properties that have unpaid taxes, but there are key differences. If you’re thinking about investing in tax deeds or tax lien certificates, it’s essential to understand these differences.

Purchase type

One key difference between tax deeds and tax lien certificates is what you’re actually buying.

When you buy a tax deed, you’re buying a piece of real estate. You immediately become the owner of the home in the tax deed.

With a tax lien certificate, you’re buying the legal right to collect unpaid property taxes, plus interest and fees. If those taxes go unpaid, you can begin the foreclosure process and may eventually own the home, but buying a tax lien certificate does not guarantee eventual ownership.

Redemption rights and timelines

When a homeowner fails to pay their property taxes and is facing a tax deed sale or tax lien, they have a right to keep their home by paying their outstanding taxes. This process is called redemption.

In general, the redemption period is shorter for tax deed sales than for tax lien certificates. Remember, with a tax lien, you’re only buying the right to collect unpaid taxes. You can only foreclose if the homeowner continues to not pay the bill. The homeowner may have the right to redeem their home up until the last moment before you finish foreclosure proceedings.

Timelines for redemption vary by state. For example, in Massachusetts, homeowners have up to 180 days after a tax deed sale to redeem their home. In Arkansas, sales are final. Homes can only be redeemed until 4 p.m. the day before the sale.

Costs

Tax deeds usually are more expensive than tax liens because a tax deed immediately transfers ownership of the property to the buyer. Tax liens only transfer the right to collect unpaid taxes, which could be only hundreds or thousands of dollars.

There also are costs that come into play after an investor buys either a tax deed or lien. Often, homes sold with a tax deed are in disrepair, and the investor needs to pay for repairs before they can rent or sell the home. Tax lien investors also may have to begin foreclosure proceedings if the homeowner doesn’t pay their tax bill, and foreclosing on someone can be a lengthy and expensive legal process.

Investor involvement

Tax deed investors have more up-front responsibilities than tax lien investors because they own the home as soon as they buy the tax deed. They need to pay property taxes and utility bills, and need to decide how to handle what is typically a distressed property, especially if they plan to rent it out or flip it.

Tax lien investors have fewer up-front responsibilities in that they only need to pursue payment of back taxes from the homeowner. However, their responsibility could escalate drastically if they choose to foreclose on the home.

Potential return

Tax deeds usually offer a higher potential return because investors who buy tax deeds are buying a property. They can turn a significant profit if they’re able to fix up the home and rent it out or sell it. However, the potential profit needs to be weighed against the potentially high costs of repairing the home.

Tax liens, on the other hand, usually have more predictable rates of return because investors know the amount of unpaid taxes and interest that can accrue when they buy the tax lien certificate. Usually, the interest rate for tax liens is set by the state or county government. For example, in Maine, tax liens accrue interest at a rate of 7.5% while in Mobile County, Alabama, the rate is 12%.

Use by state

Tax liens and tax deeds are both used to address unpaid property taxes. Some states use one or the other, while some use both. If you’re interested in investing in tax deeds or liens, check with your state housing agency to see which one your state uses.

Most states only have one or the other, though New York, Pennsylvania, Ohio, Florida, and Nevada use both.

Which option is best for real estate investors?

If you’re thinking about investing in tax liens or tax deeds, take a moment to think about which is the right type of investment for you.

When to invest in a tax deed property

Tax deeds give investors a chance to buy distressed properties at lower costs. They offer higher potential returns, but are less predictable than tax liens.

Because these homes sometimes require significant repairs, tax deed properties are a good fit for people who have experience with home rehab projects and can keep costs down. They’re also a good fit for people with significant capital who can handle the costs of repairs, marketing the home for sale, and paying capital gains taxes.

When to invest in a tax lien property

Tax lien investing does not offer the high-risk, high-return of tax deed properties, but it also lets you avoid the responsibility of having to repair and sell a home.

They typically make more sense for investors with less capital or less experience with home maintenance and repairs. They’re also a better fit for people who want more predictable interest payments from the homeowner.

Keep in mind that you may eventually have to foreclose on the home, which can be a complicated and expensive process.

How to invest in tax lien vs. tax deed properties

The first step is to look for local tax debt auctions. Most city, town, or county governments publish a schedule of these public auctions, so you’ll want to search their websites for this information.

After you’ve found auctions to attend, you’ll need to research properties that are up for auction and the local market. For example, a home that is up for auction in a highly desirable area is likely to attract intense bidding competition. A dilapidated home in a bad neighborhood may not see many bids, but could be hard to turn a profit on.

Choose a few target properties, come up with a plan for how you’ll turn a profit should you buy the deed or lien, and decide the amount you’re willing to pay for them. When you start bidding at the auction, make sure not to go over the maximum price you’re willing to pay.

If you win an auction, work with the local government to pay any outstanding costs and then move forward with your plan for the property.

The bottom line: Tax deeds and tax liens involve both risks and rewards

Tax deeds and tax liens are both used to address unpaid property taxes, but they work very differently for investors. Tax deeds immediately transfer ownership of the home to the buyer while tax liens give the buyer the right to collect unpaid taxes and interest, plus the potential to foreclose on the home in the future. Before investing in either, make sure you understand the differences and which type of investing is right for you.

However you plan to buy a property, there’s a good chance you’ll need to borrow money to afford the cost. If you’re ready to start hunting for a home, apply for a mortgage so you’re ready to start making offers.