Risks and rewards risk of lien investing
One of my favorite quotes regarding money comes from Oscar Wilde:
” When I was young I thought that money was the most important thing in life; now that I am old I know that it is.”
I don’t know if the Irish Poet was ever involved in “tax lien investing” (I strongly doubt it …), but some people certainly swear by this type of investment to give their portfolio exposure to real estate — all without having to actually own property. However, the process is complicated and novice investors can easily get burned. Here I can explain how investing in a tax lien certificate works and what risks are involved.
A tax lien is a legal claim that a local or municipal government places on an individual’s property when the owner has failed to pay a property tax debt. The notice typically comes before harsher actions, such as a tax levy, where the IRS or local or municipal governments can actually seize someone’s property to recover the debt.
After a municipality issues a tax lien to a past-due property owner, they create what’s called a tax lien certificate that denotes how much in taxes is owed, along with interest and any penalties. To recover the delinquent tax dollars, municipalities can then sell the certificate to private investors, who take care of the tax bill in exchange for the right to collect that money, plus interest, from the property owners when they eventually pay back their balance. Currently, 28 states allow for the transfer or assignment of delinquent real estate tax liens to the private sector.
Tax lien investors must bid for the certificate in an auction, and how that process works depends on the specific municipality. Would-be investors should start by familiarizing themselves with the local area. Contact tax officials in your area to inquire how those delinquent taxes are collected. Auctions can be online or in person. Sometimes winning bids go to the investor willing to pay the lowest interest rate, in a method known as “bidding down the interest rate.” The municipality establishes a maximum rate, and the bidder offering the lowest interest rate beneath that maximum wins the auction. Keep in mind, however, that as interest rates fall, so do profits. Other winning bids go to those who pay the highest cash amount, or premium, above the lien amount.
The winning bidder must pay the entire tax bill
What happens next for investors isn’t something that occurs on a stock exchange. The winning bidder must pay the entire tax bill, including the delinquent debt, interest, and penalties. Then, the investor must wait until the property owners pay back their entire balance — unless they don’t.
Most homeowners have a so-called “redemption period” — what’s generally one to three years – before they’re required to pay the taxes plus interest in full. But if the homeowner doesn’t return the tax debt, the tax lien investor is the one responsible for kickstarting the foreclosure process, which would allow the investor to assume ownership of the property.
Sounds too good to be true?
I recommend thinking carefully about the risks involved before jumping into tax lien investing. While some investors can be rewarded, others might be caught in the crossfire of complicated rules and loopholes, which in the worst of circumstances can lead to hefty losses. From a mere profit standpoint, most investors make their money based on the tax lien’s interest rate. Interest rates vary and depend on the jurisdiction or the state. For example, the maximum statutory interest rate is 16 percent in Arizona and 18 percent in Florida, while in Alabama the rate is fixed at 12 percent. Profits, however, don’t always amount to yields that high during the bidding process. In the end, most tax liens purchased at auction are sold at rates between 3 percent and 7 percent nationally.
If the property owner fails to pony up the property taxes by the end of the redemption period, the lienholder can initiate foreclosure proceedings to take ownership of the property. But that rarely happens: The taxes are generally paid before the redemption date. Liens also are first in line for repayment, even before mortgages.
Even so, tax liens have an expiration date, and a lienholder’s right to foreclose on the property or to collect their investment expires at the same time as the lien. After you’ve bought a lien, you may also want to pay taxes on the property in the years that follow, so no one else can purchase a lien and thus have a claim on the property.
Individual investors who are considering investments in tax liens should, above all, do their homework. I suggest avoiding properties with environmental damage, such as one where a gas station dumped hazardous material. One reason for this: In the event of foreclosure, the property would be yours. Would-be investors should also check out the property and all liens against it, as well as recent tax sales and sale prices of similar properties. If a property has other liens, that might make it harder to gain its title in the event of foreclosure.
Bottom line: While tax lien investments can offer a generous return, be aware of the fine print, details, and rules.