While everyone should pay taxes on their property, not everyone does. When they don’t, local municipalities may assess a lien against it, and take the property away from the owner. This is where you, as an investor, comes in.
What Is Tax Lien Investing?
Tax liens are a way for local governments to enforce property tax laws. These types of investments are most popular in the U.S. and UK, where the tax law allows governments to privatize the collection of taxes on property.
The result is an investment opportunity that offers attractive yields in exchange for the payoff of someone else’s tax debt. Investors buy liens at an auction, and then turn to the property owner for repayment. The repayment amount, plus a penalty, constitutes the rate of return for your tax lien investment.
Tax lien investing is advantageous as an alternative to the stock market and more traditional real estate investments, but you must understand both the benefits and the drawbacks.
Advantages Of tax Lien Investing
One of the biggest benefits of investing in tax liens is that, if the property is redeemed by the owner, you could earn a very high rate of return. In California, for example, tax lien certificates have a default interest rate of 18 percent. In some states, profits can be as high as 36 percent.
The homeowner’s redemption on a tax lien sale will generally run from two to three years. This means that the property owner has two to three years to repay you for the tax debt. If the property owner doesn’t repay the lien, you may foreclose on the property, resulting in an acquisition of property well below the market value.
Disadvantages Of Tax Lien Investing
One disadvantage of tax lien investing is that properties may not be kept up very well. If a property owner has “given up” on the property, and doesn’t intend to repay, then you may be acquiring a home with little to no value.
You will have to rehab the home to sell it. Unless you’re experienced in doing this kind of thing, it can become a losing proposition very quickly.
Another disadvantage of investing in tax liens is that they are complex arrangements and not usually suitable for novice investors. Tax liens are sold at auctions. If you’ve never been to an auction before, you’re competing against banks and hedge funds with some of the better properties on the market.
The purpose of bidding is to bid down the interest rate on the lien or to bid up the premium, which reduces your net rate of return indirectly. So, while the default rate of return may be 18 percent, it’s unlikely that popular or well-maintained properties will fetch this yield.
Some properties may be bid down to .25 or .5 percent, making them attractive only to large financial institutions who can make up the difference in volume.
As a lien holder, you have responsibilities you must fulfill. For starters, you must notify the property owner in writing that you have purchased the tax lien. This makes them aware of the fact that you own their tax debt.
Tax liens are also not investments that you can collect on forever. Liens generally last no longer than 7 years, but they may only have a repayment period of 2 to 3 years. This means you will have to actively research and buy liens on a semi-frequent basis if you want to keep earning money from them.
Finally, tax liens have a bad reputation in other markets because the basis of the profit depends on you collecting a tax debt – taxes being generally unpopular among many people. It has earned tax lien investing the nickname, “vulture investing.” If you don’t feel comfortable collecting a tax debt, you’re not going to like investing in tax liens.
Other Things You Should Know
When you buy tax liens, you should always investigate the title of the underlying property. If you do happen to take possession of it, you will want to know whether there are any other liens outstanding on the property. If there are, it may be impossible to sell it.
If the title is clear, you shouldn’t have too much trouble selling, but you pay have to run a quiet title action, because many title insurance companies and homeowner’s insurance companies, won’t touch a tax lien title.
Spend the bulk of your time researching properties. The best ones will be in nice neighborhoods, with high property values (comps), and the tax debt will be owed by motivated property owners. The ideal situation is where the property owner fell behind on tax payments because of a divorce or some unusual circumstance, but has access to investments or has a high income potential, which will all but guarantee the redemption of the property.
Finally, try to attend auctions that don’t allow online bidding or which aren’t advertised online. Online auctions, or access to the auction, draws large investors who are bid-happy, which drives down the potential rate of return on your investment.