Tax Lien Investing: What You Need To Know

This post contains affiliate links. If you click, we may receive a commission at no cost to you.

December 18, 2022
5 Minute Read

Tax Lien Investing: A good way to invest in real estate or a cramped market?

to build, reside, rent

What is Tax Lien Investing?

A Tax Lien is an alternative investment offered for sale by local governments to recover a past-due property-tax debt. Tax Liens can be placed on individual homeowners or commercial real estate owners. Tax lien certificates are available to private investors in 28 states, including Washington, D.C., Puerto Rico, and the U.S. Virgin Islands.

There are no income or minimum net worth requirements to start investing.

The sale of tax lien certificates is usually done in an auction where the successful bidder is determined by the lowest interest rate accepted or the highest cash bid.

The sale of tax Liens is a cash flow management tool used by municipalities if a property owner doesn’t pay their quarterly property taxes.

Once a municipality places a tax lien on an owner’s property, it is sold at an auction, which is usually once a year, depending on the county. Once the tax lien is auctioned to the successful bidder, the local government gets its cash immediately, and the buyer receives the right to collect the delinquent tax.

How Does Tax Lien Investing Work?

Approximately $21 billion of property taxes become delinquent yearly in the United States. And every year, around $4 – 6 billion go up for sale to institutional and individual investors, making tax lien investing a potentially lucrative way to invest in real estate without buying a property.

  1. Prepare For The Auction

    The auction process varies between municipalities. According to the National Tax Lien Association, it is best to call your local tax office to find out more information.

    Most states have annual property tax sales. To participate, investors must register and obtain a bidder number and card. Auctions can be online or in person. Larger jurisdictions usually have online auctions, while smaller ones may still have in-person auctions. Depending on the auction size, the bidding can take place on one or multiple days.

    Registrants may be required to pay a registration fee or make a refundable deposit.

  2. Investors Bid for a tax lien in an auction

    The bidding process varies between municipalities and states.

    There are two main types of bidding in tax lien sales, “Bidding Up The Cost” and “Bidding Down The Return. The opening bid is usually equal to the unpaid property taxes, penalties, interest and fees associated with offering the tax lien certificates.

    Bidding Up The Cost. Also known as premium bidding. In this process, the winning bid goes to the individual who pays the highest price above the opening bid.

    Bidding Down The Return. Bidders bid down the return on a tax lien, meaning the interest rate paid if the lien is satisfied. This means the property owner can redeem the certificate for less than the established rate, reducing the investor’s return.

    Bidding Down The Return Example: A $10,000 tax lien certificate may have an opening bid of 18%, and individuals may bid down the cost, say to 5%, meaning the winning bidder will earn a 5% interest rate if the tax lien certificate is paid back.

There are other bidding methods known as “Bidding Down The Ownership,” when the winning bidder agrees to take less than 100% ownership of the property, reducing their effective interest rate. This is used as a way for the original property owner to retain partial ownership of the property and control disposition of the property.

3. Winning Bidder Pays The Debt

The winning bidder must pay the entire tax bill upfront, including the delinquent debt, penalties, interest, and administrative fees. Most municipalities require a cash or cashier’s check upfront.

Then, the investor has to wait until the property owner pays back the past-due debt during what is known as the redemption period.

The redemption period is when the property owner has to pay their delinquent property taxes, usually between 6 months and 4 years, depending on the state.

If the property owner fails to repay the past-due debt during the redemption period, the tax lien holder has the right to begin foreclosure proceedings.

Note: Only 2% of properties with tax liens go through foreclosure. Most property owners pay back the lien. Foreclosure is expensive and time-consuming for the lien holder and can take years.

What Kind of Returns Can I Expect?

The interest rate earned varies between states and even counties. Interest rates vary. They generally range from 6% to 24% and are applied annually with simple interest.

For example, Florida has a maximum simple interest rate of 18 percent, while Iowa charges 2 percent monthly on the unpaid balance. However, most individuals shouldn’t expect to earn greater than 9% on average.

Did You Know: For a very desirable property, it is not uncommon for an interest rate to be bid down to zero, meaning no interest is paid in the hope that the property tax lien will not be repaid and the lien holder can begin foreclosure proceedings.

What Are The Advantages?

Tax lien investing can be a great way to add non-correlated assets to your investment portfolio. Below are some of the benefits of tax lien investing.

Collateralized

This is probably the most significant advantage of tax lien investing. Tax lien certificates are backed by physical property, usually worth multiples of the delinquent property taxes, thus providing a level of security for investors.

Relatively Safe Investing Opportunity

Tax lien sales are controlled and administered by state governments, which can help reduce the amount of potential fraud, providing investors with a safe opportunity for investing their money.

Market Insulation

State tax law determines the interest rates on tax liens. As an investor, Your interest rate is not subject to market fluctuations or changes in interest rates set by the Federal Reserve.

Potential Tax Benefits

Investments in tax lien certificates qualify for inclusion in a self-directed IRA, like the type offered through Rocket Dollar. Self-directed IRAs allow for contribution after-tax, with tax-free withdrawals if all the requirements are met.

What Are The Disadvantages?

No Liquidity

Tax Lien certificates can take years to pay off. If you want to exit your investment early, there is no secondary market where you can easily sell your legal claim.

Competition

There is no free lunch in tax lien investing. Many institutional investors, like hedge funds and professionally managed tax lien funds, can outbid the competition and reduce yields. Leaving limited opportunity for individual investors.

Not a Passive Investment

The owners of liens need to understand their responsibilities after receiving the certificate. Typically the buyer will have to inform the property owners in writing within an agreed period. Usually, the customer is also expected to mail the second note shortly before re-issue unless payment is still not paid.

Varying Process State to State

In-person or online, it’s all done by the county, so each county for each state you’re interested in buying in will have their own system, meaning you need to familiarize yourself with each system which can be time-consuming.

How To Start Investing

There are two ways for individual investors to start investing in tax liens, as DIY’er, although this isn’t recommended, or through a professional tax lien fund manager. The National Tax Lien Association can provide a list of referrals if you are interested in investing through a professional fund manager.

Tax Lien Certificates

Tax Lien certificates are bought in a public auction through local and municipal governments. To get started, contact your local tax revenue department to understand how delinquent taxes are collected.

According to the NTLA, 2,500 cities, townships, and counties sell public debt. Some, but not all, public notice requirements provide that property tax sales be advertised for a specified period before the actual sale.

These advertisements will, in most cases, list the owner of the property, the legal description, and the amount of delinquent taxes to be sold.

Tax Lien Fund Manager

Tax Lien Fund Managers are professional investors who specialize in tax lien investing. Similar to a fund manager for a mutual fund, they pick and manage tax lien investments. A fund manager is a way to go if you are interested in passively investing in tax liens.

Tax Lien Strategies

There are two quintessential tax lien strategies: The Income Strategy and The Ownership Strategy.

The Income Strategy

This strategy is ideal when executing this strategy on properties with other liens. Usually, tax liens are senior to all other liens.

So, if Mike owes $10k in taxes on a $500k house with a $400k remaining loan balance from the bank, the bank is certainly going to cover the taxes, so they get to foreclose and keep the house rather than lose it to you (the lien holder).

You pay $10k, wait for Mike or the bank to pay you back $11,000 (10% interest), and then put that money back into the next deal you find and keep it going.

The Ownership Strategy

This strategy entails trying to find a high-value property with a relatively low tax liability where the owner is unlikely to repay their unpaid property taxes.

Say Mike bought a house in cash and then left town to start a new life in Australia, never to be again. As the certificate holder, you pay the taxes he owes, and for the redemption period to expire, usually between 6 months and 4 years, then begin foreclosure proceedings.

Eventually, the property is yours.

You can keep, flip, sell, or whatever your heart desires. You just got a $500,000 house for $10,000 plus some legal fees.

Unfortunately, this situation is incredibly rare. More often than not, the homeowner found out they are liable for some environmental remediation that could cost millions to remediate, and that’s why they disappeared.

A $10,000 investment could become a multi-million liability.

Frequently Asked Questions

How much money do you need to start investing in Tax liens?

Tax liens can start with a few hundred dollars, but more likely than not, you will need at least $3,000 – $5,000 to get started.

Are Tax Liens a good investment?

Tax lien certificates can be attractive if you understand and do your research upfront. As with any investment, don’t expect to get rich quickly overnight without the leg work.

Is Tax Lien Investing Ethical?

It depends on who you ask. Many individuals feel tax lien investing doesn’t generate a net benefit for a society, like, say, as an entrepreneur would creating clean energy technology.

Yes, foreclosure on a small-town family who fell on hard times is not enriching.

It can feel predatory.

Unfortunately, there’s no way to know how the owner became entangled in this type of situation.

So if these situations are challenging for you, it’s best to stay away.

Where can I find Tax Liens for Sale?

Call your local county tax collector and ask about purchasing tax liens to get started. Many county websites advertise the processes and provide instructions on registering for bidding.

If the county lists auctions on its website, it also lists the properties for auction, the day of sale and the minimum price for each. This list will assist in determining which property you want to buy, depending on the property type and price.

Real World Investor

Adam

Adam is the founder of realworldinvestor.com, an investing website dedicated to helping discerning individuals make the best investment decisions.

Before starting Real World Investor, he was a Senior Vice President at one of the country's largest investment banks. He has over 10 years of experience working in financial services. His experience includes working with complex derivatives while spending many years working on a trading floor.

He has a bachelor's degree in Business Administration, majoring in finance.