Tax lien investing can give your portfolio exposure to real estate without actually owning the property. But experts say the process is complicated and warn that novice investors can easily get burned. Here, we explain everything you need to know about investing in tax lien certificates, including how they work and the risks involved.
What is a tax lien?
A tax lien is a legal claim that a municipality or municipality places on a person's property if the owner fails to pay his or her property tax debt. This notice typically precedes more severe action, where the Internal Revenue Service (IRS) or local government can actually seize someone's property to collect the debt.
What is a Tax Lien Certificate?
A tax lien certificate is created when a property owner fails to pay taxes and a local government issues a tax lien. The certificate will list the taxes owed along with interest and penalties. Tax lien certificates are typically auctioned off to investors looking for a profit.
How tax lien investment works
To recover delinquent taxes, local governments can sell tax lien certificates to private investors, who then take that money, plus interest, from property owners when they ultimately pay off the balance. Undertaking the payment of taxes in exchange for the right to collect them. .
According to the National Tax Lien Association, a nonprofit organization representing governments, institutional tax lien investors, and servicers, there are currently 29 states and Washington, D.C. in which delinquent real estate tax liens are transferred or assigned to the private sector. is recognized. The process looks like this:
1. Investors must bid for tax liens at auction
Tax lien investors must bid for certificates at auction, and how that process works depends on the specific municipality. The National Tax Lien Association recommends that prospective investors start by getting to know their local area. Please contact your local tax authority to find out how your delinquent taxes will be collected.
Auctions can be held online or in person. In some cases, the loan may be sold to the investor willing to pay the lowest interest rate, in a process known as “rate reduction.” Local governments set a ceiling on interest rates, and the bidder who offers the lowest interest rate below that ceiling wins the bid. However, keep in mind that if interest rates fall, your profits will also fall.
The other winning bidder will be the one who pays the highest amount of cash or premium over the lien amount.
2. The successful bidder will pay the balance and proceed with foreclosure procedures.
What happens next for investors is not what happens on the stock exchange. Successful bidders must pay all taxes, including delinquent debts, interest, and penalties. In that case, the investor must wait until the property owner repays the balance, unless the property owner repays the entire balance.
Most homeowners have what is called a “redemption period” (usually 1 to 3 years) before taxes and interest must be paid in full. However, if the homeowner does not pay back the taxes, the tax lien investor will be responsible for starting the foreclosure process, and the investor will assume ownership of the property.
If you acquired a lien at auction, you should also learn about your responsibilities. For example, Illinois requires property owners to be notified within four months of purchasing a lien that they own the lien and may be foreclosed on if they do not pay it back. Tax Lien Investment Consultant and TaxLienLady.com. You must then send another letter before the redemption period ends.
Benefits and risks of tax lien investing
Before jumping into tax lien investing, experts recommend carefully considering the risks involved. While some investors can reap rewards, others can find themselves caught up in a barrage of complex rules and loopholes that, in the worst-case scenario, can lead to large losses.
1. Tax liens can be a high-yield investment, but not always
From a pure profit perspective, most investors make money based on interest on tax liens. Interest rates vary by jurisdiction or state. For example, the legal interest rate cap is 16% in Arizona and 18% in Florida, but is fixed at 12% in Alabama, according to the National Tax Lien Association.
However, the profits are not always that high during the bidding process. Ultimately, most tax liens purchased at auction are sold at interest rates of 3% to 7% nationally, said Brad Westover, executive director of the National Tax Lien Association.
Richard Rampel, former chief executive officer of the Palm Beach, Fla., accounting firm Rampel & Rampel, experienced this firsthand before he retired. Mr. Lampel was part of a small group that invested in local tax liens from the late 1990s until the early 2000s. At first, the partners were fine. But then large institutional investors, including banks, hedge funds and pension funds, chased those high yields in bidding across the country. Large investors helped lower interest rates, leaving Lampel's group unable to make large profits on liens.
“In the end, we couldn't do better than CD,” he says. “It just wasn't worth it considering the amount of work.”
2. Tax liens have an expiration date
If the property owner fails to pay property taxes by the end of the redemption period, the lien holder may begin foreclosure proceedings to take title to the property. But that is rarely the case. Taxes are generally paid before the redemption date. Liens are subject to repayment before the mortgage.
Still, tax liens have an expiration date, and the lienholder's right to seize the property or recover their investment expires at the same time as the lien.
After you purchase a lien, you may want to pay taxes on the property in subsequent years so that no one else can purchase the lien and have a claim on the property.
“It could be six months after the redemption period,” Musa says. “Don't think you can buy it and forget about it.”
3. Tax lien investments require thorough investigation
Above all, individual investors considering investing in tax liens should do their homework. Experts recommend avoiding properties that are damaging the environment, such as properties where gas stations have dumped hazardous materials. One reason is that if a foreclosure occurs, the property becomes yours.
“You have to really understand what you're buying,” said Richard Zimmerman, a partner at New York City accounting firm Berdon LLP. “Be aware of what the property is, the neighborhood, and the values so you don’t buy a lien that you can’t recover.”
Prospective investors should also check the property and any liens against it, as well as recent tax sales and sales prices for similar properties. If there are other liens on the property, it may be difficult to obtain title to it in the event of a foreclosure.
However, be aware that the information you find is often outdated.
“People get property listings and do their due diligence weeks before selling,” Moosa says. “Half of the properties listed could be gone because the taxes were paid. It's a waste of time. The sooner you do your due diligence, the better. You need to have the most up-to-date listings.” ”
conclusion
Because tax lien investing requires a lot of due diligence, it may be worth considering investing passively through an institutional investor who is a member of the National Tax Lien Association. Westover said 80% of tax lien certificates are sold to NTLA members, and the agency can often match NTLA members with suitable institutional investors. This can make the process easier to manage, especially for beginners.
Tax lien investing can yield significant returns, but be aware of the fine print, details, and rules.
“I have several clients and friends who have made large investments in tax liens, almost as a business, and are doing well,” said Martin Kass, regional director of private client services at accounting firm BDO USA. To tell. West Palm Beach, Florida. “But it's complicated. We need to understand the details.”
— bank rate brian baker Contributed to updating this story.
