What is a Tax Lien?
Investing in tax liens can be an intriguing and potentially lucrative way to enter the world of real estate investing. If you've just heard about tax liens for the first time, you might be wondering what they are and how they work. Simply put, tax liens are legal claims placed on properties by local governments when property owners fail to pay their property taxes. Investors can purchase these liens at auctions, and in return, they are entitled to collect the unpaid taxes plus interest. In some cases, if the taxes remain unpaid through the end of the redemption period, the lien holder may be able to acquire the property itself, making tax lien investing an appealing option for those looking to diversify their investment portfolio. In this article, we'll walk you through the basics of how tax lien investing works, its risks, and the potential rewards.
Understanding Tax Liens
In many states across the county, a tax lien is placed on a property by a local government when the property owner fails to pay their property taxes. These taxes are typically collected annually by municipal or county governments to fund local services, such as schools, public safety, and infrastructure. When a property owner doesn't pay their taxes, the government has the legal right to place a lien on the property. The government then sells the lien to investors, often through an auction process, as a way of collecting the unpaid taxes.
When you purchase a tax lien, you're essentially stepping into the shoes of the government, acting as a lender, and agreeing to pay the outstanding tax bill. In exchange, you gain the right to collect the debt plus interest, often at rates much higher than what you'd find in traditional investments. This interest rate varies from state to state, and sometimes county to county, but it's not uncommon for tax liens to offer interest rates in the range of 10% to 24%.
How Tax Lien Auctions Work
Tax lien auctions typically take place at the county or municipal level. The process is usually open to the public where interested buyers can register for the auction. Traditionally, auctions took place in person, sometimes on the local courthouse steps, but today they can be conducted either in person or online, depending on the jurisdiction.
During the auction, investors bid on the tax liens. The exact auction process can vary, but one of two formats is generally used.
Premium Bid Auction
In an auction with a premium bid format, the winning bidder is the one who is willing to pay the outstanding tax debt plus the highest premium for the lien. The interest rate is fixed in this format, and typically only the tax debt bears interest, not the premium itself.
The winning investor will be required to pay the amount of their winning bid, plus any auction or document filing costs.
Bidding Down the Interest Rate
In this format, the winning bidder is the one who agrees to accept the lien with the lowest interest rate. The government typically sets a maximum interest rate for each tax lien, and the auction operates on a bidding-down basis, meaning bidders compete to offer the lowest interest rate. The investor who offers the lowest rate wins the lien. In a handful of states, when an auction is bid down to 0% interest, the auction switches to a non-refundable premium-bid auction.
Once an investor wins the lien, they are required to pay the amount owed in taxes, plus any fees or penalties that have accrued. The property owner still has the opportunity to redeem the property by paying the outstanding taxes, plus the interest owed to the investor, within a specified redemption period.
The Redemption Period
One of the key features of tax lien investing is the redemption period. After you purchase a tax lien, the property owner typically has a set period of time to redeem the property by paying off the back taxes, interest, and any associated fees. This redemption period can range from a few months to several years, depending on the jurisdiction. If the property owner pays off the debt within this time frame, you, as the lien holder, are paid the amount you invested plus the interest.
In most states, the tax lien investor should pay the annual taxes after purchasing a lien, in order to prevent a new lien from being sold to a different investor. Some states have specific procedures for paying the taxes as the tax lien holder, but investors should always retain receipts and documentation when making tax bill payments.
Tax lien holders do not own the property, but they may have certain obligations, which can vary state to state, to keep the property up to code. Some states have laws that specify how much can be recovered per year in maintenance costs, should the property owner pay the tax debt.
If the property owner doesn't redeem the lien within the redemption period, you may be able to foreclose on the property and take ownership. Like other aspects of tax lien investing, this process usually has very specific state laws that dictate timing and form of notices, tax deed applications, or foreclosure actions. Taking ownership of the property can be a lengthy and expensive process, but also a potentially huge reward for relatively little money, as long as the amount paid at auction together with subsequent tax payments and costs doesn’t exceed the value of the property.
Risks of Tax Lien Investing
While the potential rewards of tax lien investing can be attractive, it's important to understand the risks involved. Some of the main risks include:
- Overpaying for Liens: During auctions, competition can drive up prices, potentially leading to overpaying for liens. If you bid too much, the return on your investment may not be worth the risk. Do your due diligence on properties before making a bid.
- Missing Subsequent Tax Bills: During the redemption period, understand how and when to pay tax bills on the property to prevent it from going to auction again.
- Burden of Notification: In most states, as the tax lien holder, it is your responsibility to follow state law to find and notify property owners, mortgage companies, and other parties that hold an interest of your intent to take ownership once the redemption period ends.
LienSpot can help mitigate these risks by providing you with valuable insights into the performance of your investments and the specifics of each jurisdiction’s processes. You can track the costs involved, monitor the status of your liens, and be notified when it’s time to take action on your lien so that you can make more informed decisions to reduce these risks.
Potential Rewards
Despite the risks, tax lien investing offers the potential for significant returns. The primary benefit of investing in tax liens is the high interest rate that you can earn on your investment. In some cases, the interest rate can be as high as 10% to 24%, depending on the local laws and auction rules.
Additionally, if the lien isn't redeemed, you may be able to acquire the property at a significant discount. For example, if the cost of purchasing and servicing a lien is $10,000 and the property is worth $100,000, you may eventually be able to foreclose on the property and take ownership. However, this process can be lengthy and not without additional risks.
Getting Started in Tax Lien Investing
If you're considering entering the world of tax lien investing, the first step is to research the laws and procedures in your local area. LienSpot has guides for many states to help you compare the regulations governing tax lien sales, the redemption periods, and the foreclosure process. With all of the variation from one state to another, for beginners and seasoned pros alike, this can be overwhelming without the right tools.
Let LienSpot manage your tax liens to stay on top of things and make life simple. The platform provides in-depth state-specific schedules and notifications. Time to order a title search? LienSpot has you covered. Need to send certified mail and document responses? We do that too. Whether you're just getting started or have decades of experience, LienSpot can make tax lien investing easy.
Conclusion
Tax lien investing offers a unique opportunity to earn high interest rates while potentially acquiring valuable real estate. However, like any investment, it comes with risks that require careful management. LienSpot helps you to easily track state-specific procedures, tax bill payments, title searches, notices, and the performance of your investments. With the right tools and knowledge, tax lien investing can become a profitable addition to your investment strategy. With the right strategy and the best tools to manage your portfolio, tax lien investing can become a profitable part of your investment strategy.