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 houses. One example is investing in tax lien certificates. When a property owner is behind on their taxes, you can buy these certificates and collect interest on those unpaid taxes.

Key Takeaways:

• Buying a tax lien certificate from the government means an investor takes control of someone else’s unpaid property taxes. They pay off the taxes themselves, then get repaid with interest by the property owner.
• Investors profit from the interest on paid overdue property taxes or gaining the property through foreclosure.
• Tax lien investing is complex and requires a lot of research and planning, but the returns can be worth it if the right decisions are made.

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 sold at auction

A government can sell tax lien certificates to private investors at an in-person or online auction. The sale lets the local government recoup its losses sooner.

3. Investors bid on the tax lien certificate

Auctions can be based on a fixed cash amount or an interest rate. In the case of cash offers, the certificate goes to the highest bidder. In the case of an interest rate, it goes to the lowest bidder. Keep in mind that the lower the interest rate you bid on a tax lien certificate, the lower the profit you’ll make. Bidding wars on tax liens can bring down potential profit.

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 estimate 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.

• Interest rate returns: Interest rates can vary depending on where you live. For example, the interest rate on delinquent taxes in New Jersey starts at anywhere from 8% – 18% and each bed reduces it. In Alabama, the rate is fixed at 12%.
• 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 he property 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 invest in tax liens

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:

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.

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.

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?

Enter the auction

If you’re confident you’ve found a property that you want to bid on, 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

While tax lien investing can offer generous returns, there are risks no matter what happens. If the property owner pays off the debt quickly, you’ll find very small returns. On the other hand, if they fail to pay and you foreclose on the property, you might find yourself burdened with a property you can’t sell. That said, it’s possible for a successful sale to bring in major returns.

If you think tax lien investing is for you, read about the top six tax benefits of real estate investing. If you’d rather look into more direct real estate investing and want to purchase an investment property, get started with an online application today.