Tax lien investing: What you need to know

Real estate investing may sound intimidating, but it doesn’t have to be. It’s not all about flipping houses or being a landlord. There are other ways to get into the market without buying physical property. One prominent example is tax lien investing. When a property owner falls behind on their payments, you can purchase tax lien certificates and collect interest on those unpaid taxes, providing a unique entry point into the real estate world.

To better understand how these claims function, it helps to learn more about what a lien is and how it affects property ownership.

Key takeaways:

• Investing in a tax lien certificate involves paying off someone else’s unpaid property taxes in exchange for the right to be repaid with interest.
• Investors generate profit through high interest rates on delinquent tax payments or, in rare cases, by acquiring the property via foreclosure.
• While potentially lucrative, tax lien investing is a complex process that demands significant research and local legal knowledge.

What is a tax lien on a house?

A tax lien is a legal claim on a property to collect unpaid taxes, including any accumulated interest. If a property owner fails to pay taxes, the city or county government where they live will put a tax lien on the property.

When this happens, the local government issues a tax lien certificate. This document details how much the property owner owes, and if the lien remains unpaid, the property can be auctioned off to investors. An investor will then pay off the taxes, which means the government recoups its losses. The property owner then repays the delinquent payments to the investor, who gains a profit interest. If the property owner can’t pay, they risk foreclosure, and the investor might get the house.

Tax liens vs. mortgage liens

There are many types of liens that can be put on a property. Besides tax liens, mortgage liens are quite common. This is when the property owner falls behind on their mortgage payment, and they are placed by the mortgage lender and not the government.

What is tax lien investing and how does it work?

Tax lien investing entails buying tax lien certificates at auctions. Investors then have the legal right to collect the unpaid property taxes on a home or property, plus interest and penalties. However, investors must enforce the certificate within a specific time frame. Tax lien investing isn’t allowed in all states, so learn where your state stands on it before you begin making plans.

Tax lien investing is very different from stock market or bond investing, so let’s go over how it works.

1. A municipality creates a tax lien certificate

Local governments charge property taxes to pay for government programs and services. If a homeowner fails to pay their tax bill, the local government puts a lien on the property. A certificate is created that includes the amount of tax owed, interest, and any penalties.

If the property owner fails to pay the tax bill, the government has the right to foreclose on the home or auction off the tax lien certificate.

2. The tax lien certificate is put up at auction

A government can sell tax lien certificates to private investors at an in-person or online auction to recoup its losses sooner. These sales typically occur annually at the county level and are common in states like Florida, Arizona, and Alabama. To find them, check your local county treasurer’s website or look for "Notice of Sale" listings in local newspapers.

3. Investors bid on the tax lien certificate

Auctions can be based on a fixed cash amount or an interest rate. For cash offers, the certificate goes to the highest bidder. However, in many states, bidding is based on the interest rate, and the certificate goes to the lowest bidder. This "bid-down" method is used because the government wants to protect the homeowner by ensuring they are charged the lowest possible interest rate to redeem their property.

Interest rate returns vary by location. In Alabama, the rate is fixed at 12%, but in New Jersey, rates start between 8% – 18% and are bid down from there. Keep in mind that the lower the interest rate you bid, the lower your profit will be. Intense bidding wars can quickly drive down potential returns, making it vital to have a clear strategy before the auction begins.

4. The winning investor pays the tax bill

Winning the tax lien certificate in auction doesn’t mean you own the property. When you win a tax lien auction, you must pay the tax bill, including interest and fees. While this might look like the opposite of investing, the homeowner is expected to repay these property taxes within a certain amount of time. Depending on the homeowner’s ability to pay, the process goes in one of two directions.

5. Repayment or foreclosure

If the homeowner pays their property taxes, the investor recoups their investment and gains through the interest rate they bid on at auction. If the homeowner can’t pay what they owe, an investor can start the preforeclosure process. This process varies by state. Following the laws and guidelines carefully is critical, as you can lose your right to collect the investment.

Keep in mind that foreclosures are rare, with an estimated 0.5% of unpaid property taxes ultimately going in this direction. Because someone’s home is at stake, property owners usually make their best effort to pay back the debt. This means most foreclosures are for vacant lots or abandoned properties.

What to consider when investing in tax liens

Tax lien investments can be complex. You might earn a small amount back in interest, or you might have to foreclose on someone’s home. Let’s look at some things to consider before getting involved.

• Required research and preparation: Studying the laws and regulations, the foreclosure process, the available properties, and the specific property you’re interested in are critical to protecting your investment.
• Time-consuming responsibilities: Owning a tax lien certificate means you effectively become a tax collector. You must keep track of deadlines, communicate with the homeowner, and collect the taxes yourself. If they don’t pay, you’re in charge of the foreclosure process, which can be very complex.
• Expiration dates: Tax lien certificates have an expiration date. If you don’t receive your payment or foreclose on the home before the deadline, you lose your right to recover your investment.
• Neglected properties: Before bidding on a tax lien certificate, you want to make sure the property is in good condition. If you foreclose on the house, you own the property as it is. Renovating and selling it might be more expensive than you expect.
• Competition: Commercial institutions, like banks and hedge funds, can easily outbid individual investors. This means you might have limited options that won’t bring in much profit. Always go into auctions understanding it may take some time to win.
• Emotional challenges: Tax lien investing can be seen as gambling on someone else’s potential loss of a home. Property taxes fluctuate, and some people can be caught by surprise when their bill dramatically increases. If they fail to repay the property taxes within the timeline given, you must be prepared to proceed with a foreclosure. This can pose emotional challenges, especially if you’ve been in communication with the homeowner and know their situation.

How to get started in tax lien investing

Investors can buy property tax liens at online or in person auctions. Go into the auction with a bidding strategy and know your goals ahead of time. Here are some tips for success:

1. Decide on a type of property

What type of property are you interested in? A single-family home, an apartment, a commercial property, or something else? Some properties, like vacant lots, are more likely to go into foreclosure than others. If the investment results in a foreclosure, you don’t want to find yourself the owner of a property you’re not experienced in managing or selling.

2. Contact your tax revenue office

Before entering a tax lien auction, contact your local tax revenue office. They can tell you about the local laws and regulations and let you know what’s required to participate. This step is important, so you don’t accidentally find yourself breaking any regulations.

3. Research each potential property

Once you find a few properties you’re interested in, you must do your research. What’s the property’s value and condition? Are there many foreclosures in the area? Are there other liens on the property that could compromise the investment? What is the timeline for a tax lien on it? Are you prepared to address any potential issues if you find yourself foreclosing on the property?

4. Enter the auction

If you’re confident you’ve found the right property, you can bid on it at auction. Don’t be discouraged if you don’t win every property, and don’t get too caught up in the bidding. Make sure you stick to your limits.

The bottom line: Tax lien investing brings risks and rewards

Tax lien investing offers a unique path into the real estate market by allowing you to purchase debt rather than physical property. While the potential for high interest rates and even property acquisition is attractive, it requires significant legal research and a clear understanding of local auction rules. You must be prepared for the responsibilities of debt collection and the possibility of lengthy foreclosure processes. Ultimately, for those willing to navigate the complexities, it can be a rewarding way to diversify an investment portfolio.

Ready to take the next step in your real estate journey? Apply today with Rocket Mortgage to explore your financing options.

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