Tax Lien Investing Explained

Are you an experienced investor who is interested in minimal risk and higher returns? 🎯

With the economy and the stock market in dubious health, more and more investors are looking for assets that will protect them in case of a recession while still offering good returns in normal scenarios. Tax lien investing (when done right) is not only a safer option, it can potentially earn you an 18% return on investment (ROI).

While earning higher returns typically requires more risk-taking, tax lien investing offers minimal risk for investors with experience or knowledge in real estate who are willing to perform due diligence. Minimal risk and higher returns sounds like a pretty sweet deal, right?

Well if it’s so great, why haven’t you heard of it before, you’re wondering? Let’s face it, nobody particularly likes discussing taxes, they can seem boring and bring up some unwanted feelings, to say the least. Bringing it up at the dinner table is sure to get a look or two (or yawn or two) from your guests.

Yet this asset class could bring you some significant benefits for the sole reason that everyone has to pay taxes. As the saying goes, there’s only two things we can’t avoid in this life: death and paying taxes. That said, not everyone will or can pay the taxes they owe. 

Strategizing for this, in addition to other key factors, will put you in a much stronger position from the get-go, and enable you to take full advantage of the benefits of tax lien investing.

In this guide, we will help you navigate the world of tax lien investing by:

• ☑️ Highlighting the benefits of tax lien investing.
• ☑️ Mapping out the best strategy to minimize the potential risks.
• ☑️ Helping you discover the best alternatives if it’s not for you.

The Basics of Property Tax 🧾

At some stage or another, you’re likely to have heard about property taxes charged by Governments. It’s just another form of tax that property owners are required to pay.

The revenue from property tax goes towards public services such as libraries, schools, roads, community centers, recreation centers, and the police. Although property tax is a key means of revenue for local regions, there has been no broad consensus on whether these taxes are regressive, proportional or progressive, according to the Tax Foundation.

Those who take out a mortgage to finance their homes are likely paying a sum per month that covers property taxes, too. Your mortgage provider keeps your money in escrow and redirects some of your mortgage payment to the county when it’s due.

The amount of property tax liability will depend on the market value of the individual real estate. The Tax Foundation tells us,  this is calculated by “multiplying the nominal property tax rate by the assessment ratio (the percentage of the value of the property that is taxed) by the value of the property.”

These rates vary a lot depending on where you are though. Different jurisdictions charge their own rates for example in 2016, while Hawaii charged a low rate of 0.27%, New Jersey charged a higher rate of 2.35%. According to the U.S Census Bureau, on average, the property rate for single-family homes in the biggest city in each U.S states borders about 1.5%. American households spend an average of $2.149 on property taxes per year, for their homes.

The jurisdiction where the property is located will usually determine the local Government that you pay taxes too. 

Tax Lien Certificate 📃

When a property owner fails to pay these taxes, the taxman has the authority to place a lien on the property; a legal claim against the property for the amount of tax owed. Once a property has a lien attached to it, it cannot be sold or refinanced until the due taxes are paid and the lien is removed. Counties depend on this money to meet its budget criteria so it won’t be forgiving of those who don’t pay.

Once a lien is issued, a tax lien certificate is created by the authority that is owed the tax, reflecting the amount owed, in addition to any interest accrued or penalties due.

While the process does differ from country to country, in some cases, local governments are allowed to auction these certificates at public auctions to the highest bidder. Tax liens can be bought for as little as a couple of hundred dollars for smaller properties.

Tax Lien Investment Example 📊

Let’s look at an example to illustrate. Say you are the highest bidder of a tax lien and it carries an interest rate of 8% which equates to $160 per annum.

The interest here will accrue monthly so to figure out how much you will owe each month, simply divide the return by 12, which is $13.33. The homeowner will redeem the tax lien over a period of eleven months, which is $146.67 interest plus a penalty fee of $75 bringing the total amount to $2,221.67.

This means your tax lien investment will bring you an 11% return on investment.

Another example you can take a look at is Bennie Smith Jr. who was looking to build his wealth quickly when he bid on two property tax liens and made some money in a few weeks.

What is the Difference Between Tax Liens and Tax Deeds? 📈

Both tax lien certificates and tax deeds have important differences. Typically, real estate investors in tax lien states buy tax lien certificates to make an interest because property owners must pay taxes, interest and the additional penalties, we mentioned above, in order to remove the tax lien.

If these are not paid then the investor might be able to take ownership of the property. Those buying a tax deed are buying the right to own the property outright.

Neither is better than the other, per se. Like anything, they both have advantages and disadvantages. Each is guided by its own set of rules and regulations, and both require research. Here is a quick breakdown of each:

What States Can You Buy Tax Liens In? 🇺🇸

The National Tax Lien Association (NTLA) outlines that tax liens can be bought across 36 states and 2,500 jurisdictions. 

The National Tax Lien Association (NTLA) outlines that tax liens can be bought across 36 states and 2,500 jurisdictions. 

These states are:

With that, 31 states sell tax deeds. Though some states sell tax liens and tax deeds.

In jurisdictions where this is the case, the tax lien certificate is sold as a tax deed after a certain amount of time elapses. States that only allow the sale of tax deeds do not issue tax liens for sale before the tax deed is sold.

Investing in Tax Liens is Accessible 📉

A good thing about investing in tax liens is you are not required to have a real estate license. You’re not required to have an LLC, and you don’t need a significant amount to begin.

When a tax lien is bought, the payment goes towards the taxes the homeowner was due to pay. In exchange, you get the certificate, which is for the sum you bought it for, plus interest. 

It’s also good that the investment is backed by the collateral of the state laws. This allows you to redeem the tax lien, including all interest and penalty fees paid. Essentially, investors are putting their hands up to pay the taxes owed and securing a fixed  interest rate, in return.

However, although tax lien certificates are negotiable instruments, no secondary market exists, apart from the likes of eBay. This means that you will not be able to sell your certificate on and it will be a long term investment.

As a whole, your certificate is your proof that an interest-earning lien on a property was bought. It’s an obligation for the first-person lien on the concerned property, accountable by law. This means that the initial debt is paid out should the property go through a foreclosure.

The (Major) Benefits of Buying Tax Lien Certificates 💲

You might have gathered so far that buying a tax lien certificate does not mean you are buying the rights to the property. You also will not have to deal with the property owner. Simply put, you are stepping forward to pay the taxes owed to the concerned local government so they can carry on fulfilling their budget obligations—it’s sound of you, really.

As a reward for paying the taxes, the local government will afford you the interest rate and late fee penalties paid by the homeowner once the taxes are paid in full. Should the homeowner fail to pay the taxes you will be authorized to take ownership of the property throughout the back taxes, fees and penalties owed to the county.

In other words, you could find yourself in one of two outcomes from investing in tax liens:

1. The tax lien certificate is redeemed and you receive the high-interest rate previously secured.
2. The certificate is not redeemed which affords you the property through foreclosure.

Really, both outcomes are attractive. The best one for you will depend on your personal financial goals.

Tax licenses offer a secured interest rate, which will vary by county. For example, in Baltimore, the annual interest rate is set at 18%.

However, it can be far higher or lower across the nation. Illinois charges an interest rate of 18% twice a year, earning you just over 36% a year.

There’s no Cap on the Investment Amount 💰

When it comes to tax liens, you can invest the minimum or an unlimited amount. Tax liens are not the same as bank accounts that are insured up to a certain amount by the FDIC. Tax liens certificates have no cap on the amount you are allowed to invest in them.

The property owner keeps their ownership status, unless he does not pay off the taxes and fees owed and a circuit judge authorizes foreclosure procedures.

As holder of the tax lien, the foreclosure process will need to be initiated by you within a certain period, usually within about 2 years. If the property is not redeemed and the foreclosure process hasn’t been started, your investment will be forfeited and you will lose out on any refund, which would not be good.

How Do You Buy a Tax Lien Property? 👷‍♂️

Although buying a tax lien certificate makes for some passive income, getting to a place where you are comfortable investing in one in particular is not so much a passive process. Anyone interested in tax liens should familiarize themselves not just with the sale process in the related jurisdiction but also with how to conduct due diligence on the investment.

To buy a tax lien you will first need to decide what property type you would like to hold a lien, like commercial or residential, or an underdeveloped property versus one with improvements. You can then get in touch with your local city or county treasurer to discover when, where, and how the next auction will be conducted i.e. online or offline.

In most cases, the country will hold a yearly tax lien auction, most of which are held online. You can register to the auction a few weeks in advance where you will be asked for a registration fee. You will then be emailed a bid identification number. 

The treasurer can also tell you the rules that will apply to the sale. These rules will set forth the preregistration requirements, accepted payment methods, and any other details that may apply. Once the auction starts, you bid on the certificates that are of interest to you.

Rules & Regulations 📜

Tax Lien investing is not governed by a central authority and thus the rules and regulations vary depending on the location. Real-estate investors are required to adhere to the rules and regulations of the jurisdiction the property is in.

Not only should you keep an eye out for the individual laws on tax lien collections, but you will often need to adhere to county-level regulations on tax liens.

Real-estate investors should take the time to research the rules and regulations of the jurisdiction that will apply to them because you could be risking losing money otherwise. It could take years to gain the skills necessary to identify and buy certificates that are worth your time, and will make you a decent profit.

Minimum Bids & Fees 💵

The minimum bid that you can make on a tax lien certificate will need to cover the gross tax, penalty fees, and interest accrued. The penalty fees include any costs related to the sale of the certificate. You will be able to easily see the minimum bid beside the delinquent property address and its ID number.

 Investors can either bid down on the interest rate on the lien, or alternatively, they could bid up a premium they will pay for it. Investors who accept the lowest interest rate or the highest premium buys the right to the certificate.

Investors can get into a bidding war over a particular property, as can be the case with auctions, which drives down the ROI the investor will receive. As mentioned previously, in rare cases this can result in the certificate costing more than the value of the property.

According to Westover, the national foreclosure rate on properties with tax liens is in or around 4%. But buyers need to be aware of the cost of repairs, along with any other hidden fees they may need to pay if they take ownership of the property.

Once you own a property you may need to enforce some unpleasant policies, or even evict occupants in the property, which may require assistance from a property manager that can really rack up your bills.

But how do you figure out which property you should invest in?

Typically, the list of available properties will have hundreds on it. To help you go through the list efficiently you will need to create a system that helps you to easily recognize and highlight the ones you want to bid on. Basically, you will need to eliminate the ones that don’t meet your investing goals, in a time-efficient way.

Conducting Due Diligence: Minimize the Risk on a Property

Conducting due diligence on a property will help you determine the maximum desired return or bid amount. In some cases, the value of the property could be less than the lien. The NTLA suggests that you divide the face amount of the delinquent tax lien by the market value of the property.

This will also help you determine whether the property has other liens that may prevent you from owning it.

 To help you do this you should verify the following:

• ☑️ The current market value of the property
• ☑️ It is recommended that you visit the property to determine its condition.
• ☑️ Whether the property is involved in a bankruptcy case.
• ☑️ Whether there are other liens such as unpermitted work, municipal fines, code violations or perhaps other tax liens like an IRS lien.

To state, you could outline your initial investment budget. Unless you have a huge amount to invest, this will help you narrow down your options pretty quickly.

Acquiring a Property 🏘️

If you are looking to earn some interest but acquiring a property is not in your sites, then keep single-family homes with a mortgage in your peripherals. These ones provide the best opportunity of being redeemed. Many countries offer a redemption rate of 90% or more.

Every real estate with a tax lien is assigned an individual number. These numbers will give you all the information you need from the county, which you can often get online. Each number holds the property’s address, the owner’s name, the property assessment, the legal description, the condition of the property, and any structures that may be on the premises.

Tax lien investing has a time frame of between one to three years, and as we mentioned earlier because there is no secondary market to sell on your certificates, you will need to be sure that you are aware this is long term investing, and not short term. You will not have any commissions to pay. But you are likely to have a one-time registration fee for the auction.

Disadvantages of Investing in Property Tax Liens 💴

Tax liens are not typically suitable for novice investors, they require investors to have experience in the area of real estate, or at least a solid knowledge base. 

Although you might secure a high interest rate, this alone is not good enough to make it a successful investment. Investors have certain responsibilities, and added fees that must be taken into consideration; they must be organized and on top of expiration dates; not to mention the fact that they might not even get an opportunity to secure the property they’re after should a larger bidder have its eyes on the same prize. 

Although this is an attractive investing option, it does require investors to have a particular set of skills and experience.

Not For Novice Investors 💶

Property tax liens can yield high return of investments, investors considering tax lien certificates will need to do their homework before taking the leap. Tax liens are not considered appropriate for novice investors or those without a fair amount of experience of knowledge about the real estate market.

More to Consider than Just the Interest Rate 💷

Investors should also know all there is to know about the property that the lien is associated with to ensure they can take ownership of the property. Watch out for dilapidated properties located in working class areas because outside of the potential ROI the property owner may not be able to, or willing to pay the tax due.

Properties with any environmental damage, like damage from chemical or hazardous materials should also, for the most part, be avoided.

Properties with any kind of environmental damage, such as from chemicals or hazardous materials that were deposited there, are also generally undesirable.

Responsibilities & Fees 👔

Owners of tax lien certificates will need to make sure they understand their role and responsibilities one they receive their certificate. Usually, the first step is to notify the property owner in writing that you have taken ownership of the certificate. This usually needs to be done within a set amount of time. 

Then a second letter must be sent once the property is coming to the redemption period and the property is not paid in full yet. This means you will need to be on top of dates, deadlines and paperwork filings

In terms of costs, unless you plan on looking after all the administration yourself you will need to hire someone to look after it for you to help keep your task lien portfolio up to date.

When you invest in a tax lien certificate not only will you need the initial investment amount, you will also need to pay for the taxes on the property up until the property is redeemed. Otherwise, another investor could swoop in and buy the delinquent taxes from you.

Tax Liens Have Expiration Dates 📅

Tax liens are not everlasting instruments. Most have an expiration date once the redemption period ends. As soon as the lien expires the holder of the certificate can no longer collect. 

If the property should go into foreclosure, which is rare but happens, there might be reasons that prevent you from obtaining the property title. For example, you might discover other liens on the property if you have not done your homework. This means that you will not be able to obtain the property title.

Furthermore, should you get the right to foreclose the property, it is time-consuming and costs a pretty penny. It is also a very long closure process which could take anywhere from a few months to years to complete.

Cash reserves will be needed for a legal counsel, and the value of the property may have dropped by then which could affect your returns.

Bigger Investors Can Outbid Smaller Ones 🐉

In recent years, commercial institutions such as banks and hedge funds have peaked their interest in property tax liens. Of course, these institutions have enormous resources and money enabling them to easily outbid other competition and in turn, drive down yields.

This has put a strain on smaller investors and made the market less accessible, resulting in some giving it up completely. However, investors can also access funds that invest in liens which can be a better way for newer investors to dip a toe into the market.

Alternatives to Buying Tax Liens 🔖

If the risks and responsibilities of investing in property tax liens have turned you off tax lien investing then thankfully, there are numerous other good options to earn a solid return of 3 or 5% on your money.

One way, as we mentioned above, is that you invest in property liens through a fund that invests in them. This is more of a passive method that could yield less returns, proportional to the amount of work you do of course, but it is a good way to bank this asset class into your portfolio without being too involved in all of the ins and outs of managing the process.

If you’ve had it with the idea altogether then there’s also a plethora of other asset classes to consider that, if done correctly, will bring you some decent returns. These include:

• ☑️ Certificates of deposit (CDs)
• ☑️ Stocks
• ☑️ Bonds
• ☑️ Options
• ☑️ ETFs
• ☑️ Mutual funds
• ☑️ REITs

 To give you a head start in this field, choosing the right broker is essential and will completely depend on your individual goals, needs, and budget. Luckily, the advent of premium commission-free brokers has made it so that you can get a top-level service, trade, and lost nothing (or very little) on fees.

The Bottom Line 🏁

Property tax liens can be a good investment option for experienced investors with experience in or knowledge of the real estate market. Those who put the time into researching and investigating the property/ies they are considering could reap the rewards of substantial returns of investment in the long term.

However, the potential risks might outweigh the positives for some and it is simply an inappropriate asset class for some investors. In this sense, property liens can be a profitable investment for those with experience in the field and an equally terrible decision for those who are not willing to put in the due diligence.

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