Investing in Tax Liens: Basics, Benefits, and Considerations

Estimated reading time: 5 minutes

Penalties for one investor could spell opportunity for another.

When a property owner falls behind on their taxes, you can pay off their outstanding tax bill in exchange for a tax lien certificate. In essence, a tax lien certificate grants you the legal rights to collect their late tax payments plus accrued interest.

If they eventually pay before a set deadline, you could receive significant interest payments. If they fail to pay before the deadline, you could gain the legal right to the property.

In this article, we’ll cover the fundamentals of tax lien investing, the potential benefits, risks, and a step-by-step overview of the investment process.

Table of Contents

• What is a Tax Lien?
• Step-by-Step Investment Process
• Potential Benefits 
• Considerations 
• Reduce Your Tax Liability
  
  

What is a Tax Lien?

A tax lien is a legal claim a local government places on a property when the owner fails to pay their property taxes.

If a property owner doesn’t pay their taxes, the city or county can issue a tax lien certificate that lists the amount owed, including interest. The government may sell this certificate at auction to investors. The investor pays the taxes owed, and in return, gains the legal right to collect the debt, plus interest and penalties, directly from the property owner.

If the owner fails to repay within the redemption period, the investor may be able to foreclose and take ownership of the property.

Not all states allow tax lien investing, and rules vary, so it’s important to review your state’s laws before getting started.

Step-by-Step Guide to Investing in Tax Liens

Here’s a brief overview of how tax lien investing works:

1. Municipality Creates a Tax Lien Certificate

When a property owner fails to fulfill their property tax obligations, their local government will levy a tax lien on the property in the form of a tax lien certificate. This will describe the amount owed, interest, and any additional penalty that municipality chooses to enforce.

This certificate will also typically give the property owner a timeline to pay the property taxes before the government will foreclose on the home or auction off the tax lien certificate.

2. Municipality Sells Tax Lien Certificate

If the property owner fails to meet the primary deadline, the municipality may choose to auction off the tax lien certificate to investors.

This allows investors to gain a profit while allowing the government to recoup its losses quickly and prevent funding hiccups.

Tax lien certificate auctions typically operate in two main ways: cash and interest rates.

In the case of an interest rate auction, the certificate will go to the investor willing to offer the lowest interest rate.

With a cash auction, the certificate goes to the highest bidder. Investors will undercut one another until they feel they can go no lower.

3. Investor Must Pay the Outstanding Tax Bill

Once you win a tax lien certificate at auction, the property doesn’t exchange hands. All this means is you must pay the current tax bill, including interest and fees. This could mean a significant financial outlay at the beginning for the tax lien investor. The potential for profit comes next.

4. Recoup Taxes or Begin Foreclosure Process

There are two ways the situation could go at this point. The homeowner could pay their property taxes, giving the investor their initial investment and any interest agreed upon in the tax lien certificate.

If the homeowner does not pay their property taxes within the designated timeframe, the investor may begin the preforeclosure process. This process is determined at the state level, so make sure to follow your state or locality’s rules carefully. Otherwise, you could forfeit the investment.

While the upside could be significant, the actual rate of foreclosures during tax lien investing is quite low. Property taxes are typically only a few thousand dollars, while the average home is worth hundreds of thousands of dollars. So, the property owner has ample incentive to find a way to pay their property taxes, even if they’re very late.

Potential Benefits of Tax Lien Investing

1. Relatively High Interest Rates

Many states set statutory interest rates that can translate to double-digit annual returns if lien is redeemed.

2. Passive Income Potential

When liens are redeemed, you receive the investment back plus interest or penalties without having to actively manage the property.

3. Secured by Real Estate

While quite uncommon, if the property owner fails to pay their property tax payments, you may gain ownership of the property itself.

4. Diversification

Tax liens don’t move in lockstep with the stock market, so they can help safeguard your portfolio from market volatility.

Considerations Before Investing in Tax Liens

There are several factors to consider before moving ahead with tax lien investments:

1. Emotional Burden

In rare cases, tax lien investing may lead to situations where the only option is foreclosure. If you’ve been in regular communication with the property owner and come to understand their situation, this could lead to difficult conversations and place an emotional burden on the investor.

2. Must Pay Attention to Deadlines

Tax lien certificates often come with strict deadlines for you to recoup the taxes or to foreclose on the property. If you fail to do so before the deadline, you could forfeit your legal claim to the investment.

3. Interest Rates Determined By State

Some states set a fixed rate for tax lien certificates. For example, in Colorado, it’s 9% plus the prime rate, while in Arizona, it’s 16%. Ensure you have a solid understanding of your state’s tax lien certificate interest rate, if applicable, as that will affect the potential profitability of any investment.

4. Time-Intensive

Purchasing a tax lien certificate essentially means that you become a tax collector. You’re responsible for communicating with the property owner, applying pressure when necessary, and eventually, collecting the taxes. Ensure you have enough time in your schedule to uphold all of your responsibilities before moving forward with the investment.

5. The State of the Property

In many cases, the owners of properties that allow the property to get a tax lien don’t leave their properties in pristine condition. Before investing in a tax lien, you’ll likely want to investigate the property to determine how much value it would be in the rare case of foreclosure. If the property isn’t worth much, that should be factored into your investment decisions.

Reduce Your Tax Liability on Tax Lien Earnings

Investing in tax liens isn’t for the inexperienced investor. Properly investing in these assets requires time, research, and the willingness to initiate foreclosure proceedings, if necessary. That said, if you’re aware of all the potential downsides of tax lien investing, it could be the perfect fit for your portfolio.

There is one final thing to keep in mind about tax lien investing: taxes.

Interest payments are typically taxed as ordinary income. Depending on your income level and state, this could mean you’re giving up a significant percentage of your profits.

There is one way to reduce tax liability on earnings from tax lien investments. It’s called a self-directed IRA (SDIRA).

An SDIRA is simply an IRA that allows you to invest in alternative assets, like real estate, precious metals, or tax liens.

Want to learn about SDIRAs? Download our free Self-Directed IRA Basics Guide. Inside, you’ll find an overview of the IRS rules, examples of what you can and cannot invest in, and a step-by-step guide to get started.