As you start investing, you may come across one of the lesser-known types of investment that’s rarely mentioned: the tax lien. The simple definition of a tax lien is that it is a legal claim made by a governmental tax authority (usually the Internal Revenue Service) against a taxpayer’s assets. This is often the last resort of the IRS to compel a taxpayer to pay their outstanding taxes.
What does a tax lien have to do with investors or investing? Local government authorities have the option of selling tax liens to investors. If an investor pays the outstanding tax bill, they get the right to collect the money and interest from property owners. Given this information, is tax lien investing a good idea?
When executed properly, this can be a lucrative scheme that can yield investors above-average returns.
In this article, InvestmentNews sheds light on whether tax liens are good investments. We’ll also explore how tax lien investing works and if tax liens are good investments.
A tax lien is a legal claim made by a local tax authority on the assets of an individual taxpayer or business. This arises when they fail to pay their property taxes.
A lien works as a form of guaranteed payment of a debt, which, in the case of a tax lien, are the taxes.
If the owed taxes are not paid, then the creditor, which in this case could be the IRS or other governmental tax authority, can confiscate the debtor’s assets.
If a taxpayer gets a tax lien on their property, it means that the taxpayer failed to pay their taxes. Local governments have the imperative to place a lien on a piece of property or assets if a taxpayer does not pay local income or property taxes.
A lien does not immediately mean that the property is certain to be sold. The purpose of a lien is to ensure that the tax authority involved has priority over other creditors seeking what is owed to them.
Another unique feature of tax liens is that investors can trade or exchange them, and this has the potential to generate more than average returns. This type of investment may be profitable, but they come with a proportionate if not higher level of risk.
To do tax lien investing, the following events must take place:
To trigger a tax lien on a home or piece of land, its owner must fail to pay the property taxes on it.
The city or county where the property is located then places a lien on the property and issues a tax lien certificate on it. Should the property owner still fail to pay the property taxes owed and any interest, then the local government can foreclose on the property.
Once tax lien certificates are placed on defaulting properties, a tax lien auction is held.
There are two ways to make bids on the tax lien certificates. Investors can bid based on:
If the bids are cash offers, then the highest bidder wins. In the case of interest-based bids, the investor willing to accept the lowest interest wins the bid. The lower the interest rate, the lower the potential profit they can make on the property.
Investors who win bids at a tax lien auction are responsible for paying the tax bill along with any outstanding interest or fees.
The investor who wins a tax lien certificate at the tax lien sale or auction gets ownership of the certificate, but not necessarily ownership of the property. The winning investor has the right to take complete ownership of the property only via final foreclosure.
For the original owners to recover their home or land, they must repay their tax bill and any outstanding interest to the investor who holds the tax lien certificate.
At this stage, the property owner is given a redemption period – a specific amount of time in which they must pay the new investor or face foreclosure.
On the deadline date, these are the possible outcomes:
When you win a tax lien at auction, there can be an expiration date in which you must initiate foreclosure proceedings. If you fail to initiate the foreclosure process, you can lose the right to collect on your tax lien investment.
Despite the recent rise in foreclosures, most homeowners pay the taxes, interest and fees owed and avoid foreclosure.
This is a legal document that serves as proof of a lien placed on a property, which can be either a home or piece of land. The lien certificate lists the details of the property, including its unpaid taxes, penalties, and fees. Tax lien certificates are generally sold at a public auction (conducted online or in person) arranged by the penalizing state authority. Typically, bidders must make a deposit and register before participating in the auction.
Tax lien certificates do not transfer ownership of the property, only ownership of the property’s tax debt. Some states use alternate terms to refer to tax lien certificates, such as:
You can look up tax lien sales or auctions online. Some states will have their tax offices put up notices and lists of the liens on their website. You may see entire sections of their official websites devoted to these auctions. A good example is how Washington D.C. handles their tax lien auctions online via what they call “over-the-counter" tax sales.
Not all states put up tax lien auctions. Some states like Texas, for example, do not sell liens to the public – they only auction off property that’s already been foreclosed.
As with any type of investment, tax lien investing has its share of benefits and drawbacks. Here’s a rundown of both:
Some of the pros involve a high profit for a small investment, with the potential of earning property! Let’s take a closer look at these benefits:
In many cases, you don’t need a lot of money to start on this form of real estate investing. Even as a beginning investor, you can start with a few hundred or a few thousand dollars for buying tax liens.
Most of the profits from a tax lien investment come from the interest on the delinquent tax that property owners must pay. Interest rates vary from state to state, but you can get higher returns in places like Florida and Alabama – the maximum interest rates are 18% and 12% respectively.
Do remember that if you significantly reduce the interest rate you’re willing to get when bidding, that reduces your profits.
There’s a chance you can end up owning the property if the owner fails to pay the outstanding taxes, penalties and fees. This means that you get to foreclose on the property and claim ownership. When this happens, you have the option to sell the property at a hefty profit or convert it into a rental or investment property.
The downside of tax lien investing includes added expenses that come with foreclosure. These types of properties can be costly and problematic. Let’s go over each of the drawbacks:
When the owner fails to pay the outstanding taxes and penalties on their property within the redemption period, you get to own the property. As beneficial to you as this may sound, the foreclosure process can be expensive, both in terms of time and money.
Do not discount the potential emotional toll of foreclosing on a property. It takes a different sort of investor, certainly one who isn’t into ESG investing, to have absolutely no issues with foreclosure.
Remember that foreclosing on someone’s home can mean rendering a family homeless. Foreclosing on someone’s land can mean taking away both someone’s home and livelihood.
Investors who didn’t do enough research into the properties they foreclosed could discover they can be more of a headache than a good investment. As in the case of the foreclosed properties in the subprime mortgage crisis of 2007 to 2010, many of the foreclosed properties were left to deteriorate until 2014.
Some property owners could decide to not pay the taxes on a piece of property that they need to dispose of. For instance, a piece of land that’s only two feet wide and four miles in length is useless to put a home or business on and is better disposed to avoid paying its property taxes. If you bought the lien on this and foreclosed on it, you’d be stuck with the same problems as the original owner.
Or worse, a lien worth a few hundred dollars could shackle you to a property that demands larger amounts in property taxes. Even if the tax ends up as a small amount, that money could have funded better, more lucrative investments.
Keep in mind also that there is no secondary market for tax lien certificates, so it can be very difficult to offload if it turns out to be a bad investment. Make sure to look behind the liens and do the necessary research on the properties they’re attached to before buying.
When an investor wins a bid on a tax lien, they must pay the tax bill along with any interest and penalties within a very short period. Although this can be a relatively small amount, it must usually be paid within 1 to 3 days.
Here’s a video that delves into more pros and cons of tax lien investing. One of the other pros is that this type of investment is safe and secured by real estate. The video also describes how there can be ridiculous returns:
How does this type of real estate investment fare against other real estate investments? Individual investors must first consider their budget, time horizon, investment goals, liquidity preferences, and risk appetite. The table below can provide a quick glance:
Real Estate investment comparisons
| Key metric | Tax Liens | Real Estate Investment Trust (REIT) | Real Estate Investment Property |
| cost of investment | can be minimal | can be minimal | usually high |
| investor’s ownership | owns the tax debt | no ownership of real estate; only shares | owns the property as landlord/landlady |
| how to buy | public auction | brokerage or other financial institution | direct purchase or via real estate agent |
| item traded | tax lien certificate | shares | property itself |
| form of income | interest & principal payments | dividends | rental income |
| average annual returns | 8% to 30% | 12.7% | 9.5% to 10.6% |
With regards to the average annual returns on these investments, note that these can vary due to several factors:
Despite its drawbacks, tax liens can still be viable. They can be used as a means of further diversifying your portfolio, and if done properly, can give you quick and potentially significant returns. For more liquidity, some advisors would suggest adding this to a portfolio that offers reliable, regular returns such as REITs.
To maximize its benefits, investors should do their due diligence and make sure that the ROI via the interest and principal payments is worth it. Avoid investing in a lien that is more likely to result in foreclosure proceedings and burden you with a non-performing asset. Before you decide on investing in a tax lien, consult a financial advisor who is well-versed in dealing with this kind of investment.
Access expert advice on tax lien investing and other investment strategies right here on InvestmentNews.
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