Tax lien investing: What to know before jumping in

Video how to make money with tax liens

Tax lien investing is an intriguing way to diversify your portfolio and gain exposure to the real estate market without the hassle of owning property. However, it’s essential to approach this investment strategy with caution. Novice investors can easily find themselves in over their heads. In this article, we’ll explore everything you need to know about tax lien investing, including how it works and the associated risks.

What Exactly is a Tax Lien?

A tax lien is a legal claim placed by a local or municipal government on a property when the owner fails to pay their property tax debt. It serves as a notice before more severe actions, such as a tax levy, where the government can seize the property to recover the debt.

Understanding Tax Lien Certificates

Tax lien certificates are created when a property owner fails to pay their taxes, and the local government issues a tax lien. These certificates detail the outstanding taxes, along with any interest and penalties. Investors can then purchase these certificates at auction, seeking to profit from the eventual repayment by the property owner.

How Tax Lien Investing Works

To recover the delinquent tax dollars, municipalities sell tax lien certificates to private investors. In return for paying the tax bill, investors gain the right to collect the money, including interest, from the property owner when they settle their balance. Currently, 29 states plus Washington, D.C. allow for the transfer or assignment of delinquent real estate tax liens to the private sector.

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1. The Auction Process

Investors must participate in an auction to acquire tax lien certificates. The specific process varies depending on the municipality. It’s essential to familiarize yourself with the local area and establish contact with tax officials to understand how delinquent taxes are collected.

Auctions can be conducted online or in person. In some cases, the winning bid goes to the investor offering the lowest interest rate, known as “bidding down the interest rate.” The municipality sets a maximum rate, and the bidder proposing the lowest rate below that maximum wins. It’s important to note that as interest rates decrease, so do potential profits.

Other winning bids may be determined by the investor who offers the highest cash amount, surpassing the lien amount.

2. The Winning Bidder’s Responsibilities

After winning a bid, the investor must pay the entire tax bill, including the delinquent debt, interest, and penalties. They then await the property owner’s repayment of their entire balance within a “redemption period” typically lasting one to three years. If the property owner fails to repay the debt, the tax lien investor initiates the foreclosure process, potentially assuming ownership of the property.

For instance, in Illinois, within four months of purchasing a lien, the investor must legally notify the property owner of their possession of the lien and the possibility of foreclosure if the debt remains unpaid. Another letter must be sent before the end of the redemption period.

Benefits and Risks of Tax Lien Investing

Tax lien investing can yield significant returns. However, it’s crucial to carefully assess the associated risks before jumping in. Complex rules and loopholes can lead to significant losses. Let’s explore the benefits and risks in more detail.

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1. Higher-Yielding Investment Potential

From a profit perspective, tax lien investors earn money based on the interest rate of the lien. Interest rates vary depending on the jurisdiction or state. For example, in Arizona, the maximum statutory interest rate is 16 percent, while in Alabama, the rate remains fixed at 12 percent. However, during the bidding process, most tax liens are purchased at rates between 3 percent and 7 percent nationwide.

It’s important to note that big institutional investors, such as banks and hedge funds, have influenced interest rates by bidding aggressively, thus reducing potential profits. Therefore, careful consideration is necessary to ensure that the investment is worth the effort.

2. Expiration Dates and Foreclosure Processes

Tax liens have expiration dates, and the lienholder’s ability to foreclose on the property or collect their investment expires at the same time as the lien. However, it’s relatively rare for foreclosure to occur, as property owners typically pay their taxes before the redemption date. Additionally, tax liens hold priority over mortgages when it comes to repayment.

To protect their investment, lienholders may choose to pay subsequent property taxes in the following years to prevent others from acquiring a lien on the property.

3. Thorough Research is Essential

Before diving into tax lien investing, thorough research is paramount. Investors should avoid properties with environmental damage, as owning such properties could become a liability during foreclosure.

Understanding the property, its neighborhood, and its value is crucial to making an informed decision. Checking for existing liens on the property and reviewing recent tax sales and sale prices of similar properties can also provide valuable insights. However, it’s important to note that information obtained during the research process may become outdated. Therefore, conducting your due diligence as close to the auction date as possible is recommended.

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The Bottom Line

Tax lien investing demands meticulous due diligence. For beginners, it may be advisable to consider passive investment options through institutional investors who are members of the National Tax Lien Association (NTLA). Around 80 percent of tax lien certificates are sold to NTLA members, who can match investors with suitable institutional opportunities. This approach simplifies the management process and reduces the complexity for newcomers.

While tax lien investments have the potential for generous returns, understanding the fine print, details, and rules is crucial. Tax lien investing is a unique investment strategy that requires careful consideration and thorough research to reap the rewards successfully. So, take your time, do your homework, and make informed decisions before venturing into this fascinating investment arena.

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