How Do Tax Liens Work?

There are different ways to make money in the property market. Some buy and sell properties for profit and others receive rental income from them. Now, investors have a new investment vehicle called a Tax Lien.

A tax lien refers to a claim by the government on the property of a taxpayer for tax default. In the process, a certificate is issued that the municipal government can auction to willing investors. The certificate holder, in this case, can receive the tax payments from the property owner plus all the accumulated interests.

Investing in Tax Lien looks lucrative but it can also be complicated. This article explains the basics of this new real estate investment opportunity.

Understanding How the Tax Lien Process Works

Essentially, the whole process starts when a taxpayer fails to pay taxes for the property they own. This forces the municipal government to place a Tax Lien (Legal Claim) on it. To the property owner, a tax lien means they cannot sell the property until the tax debt is paid or the lien is removed

Once a Tax Lien certificate has been prepared, the municipal run an auction process for it. This means that willing property investors can turn up at the auction to bid. Currently in the United States, at least 29 states allow this kind of auction.

Municipalities generally like the idea of auctioning a tax lien certificate because they are guaranteed someone will bid a reasonable quote for it and pay the money that is needed to cover the existing tax burden. The winning bid can either be:

  • The one with the lowest interest or
  • The one with the highest premium

What Lien Investors Need to Do

Prospective Tax Lien investors are expected to do the following

Decide on the property type to invest in – Every investor needs to decide if they want to invest in a commercial or residential property. They also need to decide if what they want is undeveloped land and not a property that needs improving.

Contact the Municipal Treasurer – After deciding on the type of property to invest in, the prospective investor should contact the municipal treasurer to inquire about the availability of such properties. The municipal treasurer will then advise the investor on existing opportunities and when the auction will be done. It can happen online or in a physical place.

Understand the Bidding Method – Usually, there are two bidding methods for property tax liens.

Bidding on Premium – Here, the investor who offers the highest premium (an amount above the lien value) wins the bidding and becomes the temporary owner of the lien certificate.

Bidding down on Interest – Here, the investor who bids the lowest interest (a rate lower than the municipal’s maximum rate) wins the bidding and purchases the tax lien certificate.

Is Tax Lien Investing Lucrative?

As a tax lien investor, you are required to pay the municipal government an amount equivalent to what the property owner owes as tax debt. Since it’s a bidding process, chances are that you may pay more. However, you shouldn’t worry so much as the property owner is expected to pay you back the money spent plus accumulated interests. So, you make a profit from the interests you are paid.

Ordinarily, the interest rate averages 10-12% depending on the state. In case you had opted for the premium bidding method, then the premium you paid is added to the interest you are claiming. This money is expected to be paid within three years. If this doesn’t happen, then you have the legal rights to foreclose the property.

But since most property owners will go to extreme lengths to save their property, foreclosure is quite unlikely. However, if it happens, then you would have hit the jackpot. Overall, Tax Liens are lucrative not just because you can earn significant interest but also because you don’t need so much capital. In most cases, a few hundred dollars may help you win a bid and earn a tax lien certificate.

What are the Risks?

Like all other real estate investment opportunities, tax lien purchases have risks and here are the notable ones:

  • Failure to comply with the foreclosure requirements may render your tax lien certificate invalid.
  • More often than not, the property may not be in the condition that you expect it to be, more so when you do online bidding.
  • The property owner may have filed for bankruptcy before the bidding and this legally renders a tax lien sale Invalid
  • You may have to pay taxes for the property during the redemption period and this can be expensive, especially if the period is extensive.
  • You may end up with a property that’s not productive. For example, you may end up with a marshland if you don’t do your homework well.

What Can You Do to Avoid the Risks?

You must do your homework very well before bidding for a tax lien. So, due diligence is necessary. For a start, you should understand the state laws that touch on the property you are interested in. For instance, you should understand the following:

  • The extension of the redemption period and what you can or cannot do during the period.
  • Your responsibilities as the temporary holder of the property certificate.
  • How much tax liens sell in your state.
  • How much you can gain from the certificate during the redemption period or in the long term.

Other than due diligence, the other important thing you can do to avoid the pitfalls is investing through an investment fund. A good number of real estate firms set up investment funds for tax lien certificates where not just one but several investors pool their money. They then appoint a fund manager to make decisions on behalf of the investors. If something goes wrong, then the fund manager is answerable.

What’s more, it allows you to share the risks with other investors as you are not the only one. This means you can pool your money with different companies. In the end, this helps to reduce the risks and improve your chances of earning improved interests from different sources.

Closing Thought:

In general, a tax lien can be a lucrative real estate investment opportunity for experienced and smart investors. Since there are risks, you must do some research before going ahead with the decision. You don’t want to invest in something that won’t bring profit.

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How Do Tax Liens Work?