How Tax Lien Investing Works

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One of the lesser-known forms of investing is tax lien investing. It’s a way you can collect debt payments and even potentially acquire property.

Here we’ll give an overview of how tax lien investing works, explain what it entails, and spell out the pros and cons of trying it.

Tax lien investing: An overview 

The federal government puts a tax lien on a property — basically a legal claim — when the property owner fails to pay their back taxes. 

When a local municipality or state puts a tax lien on a property because of delinquent tax, it prevents the owner from selling or refinancing the property, essentially forcing the owner to make payments or move into the foreclosure process. 

Once the taxes are paid, the tax lien is lifted from the property and the owner is allowed to proceed with refinancing or selling. Tax liens may be issued monthly, quarterly, or annually.

Tax lien investing involves buying an outstanding lien, in addition to any penalties or interest that are due on the property, and adding it to your real estate portfolio — with the goal of turning a profit, of course. 

How to invest in tax liens

Investing in tax liens starts with obtaining them at an auction. Here’s how the process works, step by step.

  1. Attend tax lien auctions
  2. Pay the outstanding lien
  3. Receive payments
  4. See what happens
  5. Fix and flip or rent

1. Attend tax lien auctions 

Stay informed about local tax lien sales and attend a local auction in your area. At a certain point, the property owner and bank receive a notice about the tax lien, and the government steps in to intervene. 

Once that happens, tax liens are sent to public auction where they can be purchased by the highest bidders. If you win the bid for a tax lien, you are issued a document called a tax lien certificate.

For more information on tax lien investing, visit the National Tax Lien Association (NTLA) website.

2. Pay the outstanding lien 

The person who wins the tax lien at auction needs to pay the lien holder (e.g., the state of Arizona or the county treasurer) the outstanding amount on the lien. This also requires paying any penalties and interest that are due on the property. 

3. Receive payments 

The winning bidder is then legally allowed to collect unpaid taxes in addition to interest and penalties from the property owner. These repayments come from the state or municipality when the person makes their property tax payments. 

States have different laws governing how much interest can be charged for tax liens. In some states, like Alabama and Florida, tax liens can be as high as 12% to 18%, respectively. 

That said, winning a bid at a lien auction requires submitting the lowest interest rate bid. So, your chances of getting the maximum rate of return that a taxing authority allows are not high. However, some tax liens are sold to individual investors and institutional investors based on the highest cash offer. 

4. See what happens 

Most tax liens come with redemption deadlines and expiration dates. The redemption deadline determines how much time the property owner has to make payments. The expiration deadline is the deadline for filing foreclosure in the event that the owner doesn’t make payments. 

Only time will tell what happens regarding the property. Either the homeowner will pay the delinquent property tax and retain full control and ownership, or they don’t — which means they’re going to lose it, making you the rightful owner as the investor. 

You can do very little during this process except sit back and wait to see what happens.

5. Fix and flip or rent

If you become the owner of the property, you can then make money off it by flipping or renting it

With flipping – or selling – you can potentially generate a large net gain. If you rent the property, you can produce a steady residual income stream. It all depends on how involved you want to be in the property, along with its condition. 

Tax lien investing: The pros and cons

Tax lien investing can potentially lead to profits. That said, there are some risks you should know about, too. To help you determine whether it could be a good opportunity for you, let’s take a look at the advantages and disadvantages of tax lien investing.

The advantages of tax lien investing

Diversify your portfolio 

It’s smart to diversify your portfolio by allocating money into different asset classes. Investing in tax liens is one way to complement your other investment vehicles. 

Strong ROI potential

By purchasing a tax lien certificate, you gain the ability to collect high-interest debt from a property owner.

The trick is to do well in an auction and get a place with a high interest rate. It’s not always easy, but it can be done. 

Opportunity to own property

Another benefit to purchasing a tax lien certificate is that you will receive the deed to a property if the tax debt is not paid during a certain period of time. 

So, depending on how much you spend at auction, you can potentially get a property for a lot less than buying it outright.

Short-term gains

Investing in tax liens can potentially lead to solid short-term gains. In many cases, homeowners wind up paying their taxes, causing the lien to expire and the arrangement to end. 

So, investors looking for short-term investments instead of long-term commitments could do well with this type of arrangement.

The disadvantages of tax lien investing

Now that we’ve looked at some of the benefits, here are some of the top risks of this investment option. 

Blind purchasing 

One of the downsides about investing in tax liens is that you don’t know what kind of deal you’re getting. Investors are shielded from any details during the auction. You don’t know what the property’s condition is, meaning you could potentially get stuck with a place that needs a lot of renovations or is difficult or impossible to sell.

Unpredictable outcomes

There’s also no telling what the property owner will do, making it hard to plan ahead. For example, you may get stuck with someone who doesn’t want to or cannot afford to make any payments. Or, you may wind up with someone who pays all of their taxes, preventing you from owning the property. 

Investors who prefer more visibility and predictability with their investments should steer clear of tax lien investing. 

Hidden fees 

There are often hidden costs and responsibilities associated with buying tax lien certificates. For example, a home may need extensive remodeling. Alternatively, it may come with tenants who require eviction, driving up costs and stress levels.

Extra work

Owning a tax lien can also create extra backend work, which can work against investors who are looking to unlock passive income streams.

For example, owning a tax lien requires notifying property owners in writing about the transaction after investors obtain a certificate. There is usually a certain window of time for this.

What’s more, a second notification is required toward the end of the expiration period.

Add it all up, and there are specific actions that need to be taken in order to execute a tax lien investment. It’s not something that you can set and forget while collecting money. 

Failure to inform tenants of your investment could result in penalties. And if the certificate ends in ownership of the property, you may be forced to spend a lot of money on renovations or even hire a property management company to look after the property on your behalf. 

Bankruptcy complications

States have varying laws regarding bankruptcy. If a property owner declares bankruptcy, it could complicate the case and lower the interest rate that you’re allowed to collect. 

Tips for tax lien investing 

There’s a lot you can’t control when investing in tax liens. However, there are some things you can do to increase your chances of getting a good deal.

Set an auction limit 

One of the best things you can do when investing in tax liens is to set an auction limit. Have some figures in mind limiting how far you will dip on interest rates or how much you will spend to land a property at auction. 

Sometimes, the best move is to walk away from an auction and avoid making a risky purchase. If you’re not confident that the investment is going to yield a strong return, you may want to consider avoiding it altogether.

Have money set aside for repairs 

It’s impossible to know what you’re getting involved with when buying a tax lien. As such, you’ll need to make sure you have plenty of money on hand to fund possible renovations and repairs in the event that you become the rightful owner.

Properties can be very expensive. You’ll want to have anywhere from $20,000 to $50,000 or more set aside just to be certain you can fund necessary projects. The last thing you want is to get stuck with a property that you can’t afford to fix.

Have contractors on standby 

Have a team of trusted contractors ready on standby to offer fair quotes and project estimates. That way, you can put them to work and flip the property or get it rental-ready as soon as possible.

Have other irons in the fire

Tax lien investing should be just one part of a much larger and more robust investing strategy. 

For example, you should also invest in things like stocks, bonds, index funds, mutual funds, and of course real estate investments like direct properties and real estate investment trusts (REITs).

Tax liens are high-risk investments, so it’s important to make sure that your portfolio is in a position to take on more risk. If you’re older, have a lot of debt, or are experiencing cash flow problems, you’ll probably want to avoid investing in tax liens. 

More information about tax lien investing

There is a lot to learn when it comes to tax lien investing. The more you learn, the better off you’ll be. 

Here are some key books on the topic to explore. 

The Complete Guide to Investing in Real Estate Tax Liens by Jamaine Burrell

Investors who want a complete overview of lien investing should look into Jamaine Burrell’s book which explains how to earn hefty returns. 

Profit by Investing in Real Estate Tax Liens by Larry B. Loftis

In this book, tax lien investor Larry Loftis offers a rundown of how to invest in tax liens and deeds. Loftis offers first-hand experiences based on the tax liens that he purchased over the years, in various locations across the U.S.

Tax Lien Investing Secrets: How You Can Get 8% to 36% Return on Your Money Without the Typical Risk of Real Estate Investing or the Uncertainty of the Stock Market! by Joanne Musa

Author Joanne Musa offers a great resource for tax lien investors. Her book offers five steps for purchasing profitable tax liens or tax deeds, how to protect your investment and maximize your return, tips for cashing in on an investment, ways to automate investing, and suggestions for getting experts to do work for you.

The 16% Solution: How to Get High Interest Rates in a Low-Interest World with Tax Lien Certificates by J.D. Joel S. Moskowitz 

In this book, author J.D. Joel S. Moskowitz offers advice on maximizing interest rates through tax lien investing during a time when interest rates aren’t very high across the board. 

Investing Without Losing: The Beginner’s Guide to Real Estate Tax Lien and Tax Deed Auctions by Don Sausa 

Another gem on real estate tax lien investing is Don Sausa’s book, which is a great read for anyone looking to get started in this line of investing.

Frequently Asked Questions 

What is foreclosure?

Foreclosure occurs when a property owner stops making payments to a lender. If a certain amount of time goes by without payment, the lender can legally seize the property and send it to auction. 

Some investors can actually make money on foreclosures by strategically acquiring the distressed properties.

Is it profitable to invest in tax liens?

Investing in tax liens can potentially lead to high gains. It largely depends on the length of the certificate’s term and the interest rate you lock into. 

It’s also important to factor in costs, which can detract from profits. For example, the certificate owner has to pay the remaining balance in addition to penalties. There could also be further costs associated if the holder takes ownership of the property down the line (e.g., renovations and upkeep). 

Should I buy multiple tax lien certificates?

Buying multiple tax liens at a time can increase risk. The general rule of thumb is to buy one at a time until the lien expires. However, if you have the means to buy more than one, there is no law against it. 

Can I buy tax liens with my self directed IRA (SDIRA)?

You should be allowed to invest in tax liens through your self-directed IRA. If you’re interested in pursuing this option, talk to your SDIRA custodian to see what they recommend. 

If you decide to go this route, the custodian will pay for the tax lien certificate using money in your IRA. All proceeds that you make from the real property will flow back into the SDIRA for tax-friendly growth.

The Bottom Line 

There are tons of investment strategies to explore in the real estate market, and one of the more interesting ones is tax lien investing. 

This strategy involves buying tax liens placed on properties with unpaid property taxes. By purchasing delinquent property taxes, it’s possible to profit from tax revenue and interest rates.

Just make sure to do your due diligence with this strategy, as you should be doing with all your investment opportunities. Tax lien investing can be profitable, but it’s also risky. 

If you’re just starting out as a real estate investor, you will probably want to try your hand at REITs before graduating to this level of sophistication. But over time, you may very well become a shrewd tax lien investor who’s eager to soak up deals most investors overlook.

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