How to Invest in Tax Liens [Beginner’s Guide]

Investing in tax liens is a way to invest in real estate, but they can be complex and carry many risks.
Last updated April 19, 2022 | By Roger Wohlner | Edited By Michael Kurko
Real estate sale auction

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According to the Urban Institute, state and local governments collected $577 billion in revenue from property taxes in 2019. The delinquency rate for the same year was 5.6% resulting in $32 billion in delinquent property taxes. Some of the outstanding tax from real estate are offered to private investors through the sale of tax liens.

Currently, 30 states and several territories sell tax lien certificates, offering individuals a way to invest in real estate without buying property. We’ll take a look at how tax lien investing works as well as its risks and rewards to help you decide if it’s right for you.

In this article

How does tax lien investing work?

Tax lien certificates are offered for sale by local, county, and municipal governments in an effort to recover delinquent property taxes. The certificates are typically sold by public auction with either the highest cash offer or lowest interest rate offer constituting the winning bid.

Tax lien investing differs from investing money in stocks, bonds, ETFs, or mutual funds. When a property owner fails to pay their property taxes, a local municipality or county will place a tax lien on the property and create a tax lien certificate. The certificate includes information such as the amount of tax due as well as any interest or penalties on the delinquent taxes.

If the property owner doesn’t pay their property tax bill, including any interest payments, some states will put the tax lien up for auction. Local governments can sell tax liens to individual investors in 30 states, usually via an auction. States that sell tax liens may have registration requirements for anyone who wants to bid on a tax lien at auction, you will need to contact your state or local tax agency for more information.

At the auction, investors bid on the tax lien certificates either for a set amount of cash or an interest rate they’re willing to accept. In the case of cash, the highest bidder wins since they are offering the most money for the certificate. In the case of an interest rate, the bidder who is willing to accept the lowest interest rate as a return on their investment wins.

The winning bidder then takes control of the property and is immediately responsible for paying the tax owed on the property. After this, the property owner has a set period of time in which they must pay back the winning investor or risk losing the property through foreclosure.

At this point, there are two possible outcomes. If the property owner pays the property taxes due, the investor makes back the amount they paid for the tax lien plus the interest rate they bid at auction. If the property owner defaults on their tax payment, the lien holder can foreclose on the property and take ownership of it.

Tax liens vs. mortgage liens

A mortgage lien allows a lender (typically a bank) to make a legal claim on a property if the homeowner is unable to pay their mortgage loan. Typically there is a legal process once the borrower defaults on their loan that must be followed in order for the mortgage holder to exercise their lien and take possession of the property.

In comparison, a tax lien is a lien against the property arising from unpaid property taxes. The local or municipal entity to whom the property taxes are owed will file a lien. Property tax liens typically have a priority status over a mortgage lien, but a tax levy by the IRS will typically have priority over both types of liens.

Benefits of tax lien investing

The interest rate of return on tax lien investing varies in part by the state in which you purchase the lien. For instance, tax liens in Florida are capped at a maximum interest rate of 18%, and in Arizona, the maximum rate is 16%, while tax liens in Alabama carry a fixed rate of 12%.

Investors should understand that these rates are simple interest rates, and some state laws allow investors to bid down rates. Nonetheless, the returns on tax lien certificates could be significant for investors.

There are also ways for investors to invest passively in tax lien certificates without attending an auction. This can be done through a professionally-managed fund similar to a private or mutual fund.

Finally, aside from federal liens (such as IRS liens), tax liens supersede mortgage liens and any other liens in order of priority. If the property needs to be foreclosed to satisfy the property owner’s tax debt, the holder of the tax lien is usually first in line to get ownership of the property.

Downsides of tax lien investing

Owners of properties that have dropped in value or become worthless may not want to pay their property taxes and might just walk away. This can leave the owner of the lien with a property that will be hard to sell and that won’t bring much of a selling price if sold.

Tax liens can also have an expiration date, and many states limit the amount of time that the holder of the tax lien has to foreclose on the property if the owner doesn’t pay their taxes.

Tax lien sales can be competitive, which can drive the interest rates down. This is often true if institutional investors take an interest in tax liens in a particular area or for a certain type of property.

While there are funds that allow a passive investor to participate in tax liens, buying a tax lien outright is anything but a passive investment. An investor needs to do a lot of homework and monitoring to succeed in tax lien investing.

How to invest in tax liens

Here are a few steps to consider as you get started.

  • Decide on a target area in which to focus your tax lien investing activities. Tax lien auctions are typically handled at the county level. The adage in real estate is “location, location, location.” This is true when it comes to investing in tax liens. Factors to consider include the financial situation in a county and the types of properties for which tax lien certificates might be available.
  • Choose the property you want to focus on. These could be single-family homes, rental properties, land, or commercial/industrial buildings.
  • Identify the properties available and try to learn as much as you can about the ones that interest you before the auction. Tax lien investing is no different from other types of investing in that the more you know, the better decisions you’ll make.
  • Follow all of the rules connected with winning and holding the tax lien certificate. In some states or at the municipal level, this might entail sending a certified letter to the property holder informing them that you have purchased the lien and how much they owe in back taxes.
  • Join the National Tax Lien Association (NTLA): The NTLA is the only national non-profit trade association focused on tax lien and tax deed sales in the U.S. The association offers education on tax lien investing as well as a path to becoming a Certified Tax Lien Professional (CTLP).

If all goes well and the property owner is able to pay their back taxes, all you have to do is collect the amount you paid for the tax lien with interest. If things don’t work out, you will have to go through the foreclosure process and ultimately take possession of the underlying property.

FAQs

Is investing in tax liens a good idea?

Tax lien investing could be a smart investment since the interest rates in some states can be high. It might not be the right investment strategy for a small or novice investor since the results could be disappointing if the tax lien can’t be collected on.

Investors who already have a diversified portfolio and sufficient capital to invest might be a smarter fit for this type of real estate investing. It’s important that anyone considering this route fully understand the potential risks and rewards.

Can you make money investing in tax liens?

Tax liens could be a high-yield investment opportunity, especially in states with high maximum interest rates. However, the bidding process can serve to lower the ultimate interest rate, so investors need to be careful not to focus solely on winning the auction, but rather on obtaining the lien with a solid interest rate.

In the best-case scenario, you would win the auction at a competitive rate, the property owner would make all of their required repayments, and you would receive the interest and the amount you paid for the lien in a timely fashion.

However, if you have to foreclose and take possession of the property, things can get pricey. If you are able to sell the property at a competitive price in a reasonable period of time, you could make a profit. If not, a potentially profitable investment can become a financial drag.

What are the risks of buying tax liens?

The value of the property under a tax lien could be worthless or have a very low value. Maybe the property owner has not maintained the property, or it’s been damaged by a natural disaster. If you buy the lien and are forced to go through the foreclosure process, you may spend time and money on an asset you’ll have to pay property taxes on and will likely have trouble selling.

The foreclosure process can also be slow, and the property value can drop during this time. Be sure to do your homework on the specific property and the real estate market in the area surrounding the property.

Finally, if the property owner files for bankruptcy, the tax lien could be considered one of the debts they owe, and the lien could be tied up in bankruptcy proceedings for a long time.

Bottom line

Investing in tax liens could be a smart idea for investors who already have a solid, diversified portfolio and are looking to add an alternative asset class. It can also be a way to invest in real estate without actually buying properties.

As with any type of investment, be sure to do your due diligence and make sure you understand what you’re investing in, including all of the financial risks and benefits, before buying any tax lien.

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Author Details

Roger Wohlner In addition to his bylined articles on sites like TheStreet, ThinkAdvisor, and Investopedia, Roger ghostwrites extensively for financial advisors, investment managers, and financial services companies.