What Is Tax Lien Investing?

Key Takeaways

• Tax lien investing allows you to purchase a tax lien certificate issued by the local government when a property owner has unpaid property taxes.
• A tax lien certificate includes unpaid taxes along with interest and fees. The investor purchases this debt and is repaid with an agreed-upon interest rate when the property owner wants to redeem the debt.
• Many REITs require investment minimums of thousands of dollars, and obtaining a home mortgage comes with a significant downpayment; tax lien certificates can be purchased for a few hundred dollars.

Real estate investing has been a hot topic lately as interest rates continue to climb, making housing prices unaffordable in most parts of the country over the last few years. Many hopeful real estate investors have been looking for other ways to get into the market.

As the fears of a housing market crash continue to build momentum, it’s worth mentioning that there’s another way to invest in real estate. You may have heard of tax lien investing, which can be potentially lucrative since an estimated $21 billion of property taxes become delinquent annually.

We’ll look at how you can start investing in tax lien certificates and the risks associated with this style of real estate investing.

What is a tax lien?

A tax lien is a legal claim placed on an individual’s property by the local or municipal government when the owner hasn’t paid a property tax debt. So let’s say an owner of a house, building, or any land doesn’t pay their property taxes to the local government within the appropriate time. As a result, the government creates a tax lien certificate and places a lien on the property. The tax lien certificate includes the amount of unpaid taxes due along with interest and other possible penalties. The property owner is then given a specified period to pay the outstanding balance before the foreclosure process begins. A tax lien is a warning from the government that the property owner must pay their taxes.

There are currently 28 states with about 2,500 jurisdictions (cities, townships, and counties) that allow the selling of public tax debt. Not every state allows the public sale of delinquent property taxes, so check to see if this is an option in your state.

How does tax lien investing work?

Tax lien investing is a bit different than any other kind of investment. You must purchase the tax lien certificate at auction. Your goal as an investor in tax liens is to find auctions where you could purchase these certificates. You make money because the government gives the owner a specified amount of time to redeem this certificate, with a set interest rate that you’ll earn. You then wait for the owner to make the payment. You get your initial investment back – the money you spent on the tax lien certificate, which includes the taxes, interest, and fees – plus the set interest rate.

How can you invest in a tax lien?

The process of investing in a tax lien can seem intimidating at first. Here are the steps involved if you want to invest in a tax lien:

1. Find a state and jurisdiction that auctions tax lien certificates. You want to look around for auctions (they can be online or in person).
2. Attend and try to win an auction on a tax lien certificate. You want to research in advance to ensure that there are tax liens worth bidding on.
3. Win a tax lien certificate. The certificate will typically be sold by the cash amount an investor is willing to pay for the certificate or the interest rate that they accept. The certificate goes to whoever is willing to pay the amount in cash or willing to accept the lowest interest rate.
4. Pay the unpaid taxes and other fees to obtain the tax lien certificate. You have to cover the taxes and interest immediately to the certificate. You’re purchasing this debt and the fees associated with it.
5. Wait to see if the homeowner will redeem the tax lien certificate. If the owner doesn’t pay the debt off, you must go forward with the foreclosure process.

A tax lien certificate could also lead to a bigger investment return. The taxpayer is given a specific time to pay off the tax lien certificate. If they don’t pay off this debt, the investor obtains the deed to the property. You could become the owner of this property for a fraction of what it would cost on the market. You could then turn around and sell it, or rent out the property out indefinitely.

We suggest that you take the time to learn about the property and its jurisdiction to know what you’re investing in. Do this research in advance to know what you’re signing up for before attending an auction.

Pros and cons of tax lien investing

Let’s take a look at the benefits and the setbacks of investing in tax liens:

Pros

Low investment cost. You don’t have to make a hefty mortgage down payment to buy a tax lien certificate. You can buy tax liens for a few hundred dollars.

Diversification. You can diversify by purchasing multiple certificates in different communities. Since you’re not putting up much money, you can look into tax lien certificates across different jurisdictions.

Guaranteed returns. You know what kind of return you should expect on your money as the interest rate is set. For example, the interest rate in Florida varies from 0% to 18%. You don’t have to guess how much you’ll make on your investment. This return could also be higher than most investments out there these days.

Cons

The property owner may not redeem the tax lien. There’s no guarantee that the owner will want to settle this debt. You’d foreclose on the property in this case, which will give you a piece of real estate for pennies on the dollar, but the process can be messy and drawn out.

You may have to wait a long time to see your money. The property owner is given a specified period to pay off their tax lien. This could be up to three years.

The property may have other issues. Look into the details to ensure that there are no environmental issues with the property before you invest.

Is tax lien investing risky?

Since you don’t own the actual property, you don’t have to worry about maintaining it or dealing with tenants. On the flip side, you risk the debt not being paid back. You have to factor in the risk involved with the homeowner declaring bankruptcy. When the property owner is in bankruptcy, the IRS and other creditors could get involved if they have claims on the property. Your tax lien would then be useless, as other creditors will be paid back before you.

You must work with a real estate lawyer and get to know as much as possible about the local laws. Every state has different rules when it comes to tax lien certificates and what steps you should follow from the moment that you purchase the debt.

Should you try tax lien investing?

As an investor, you should always look for the best ways to maximize the returns on your money. While you could get into tax lien investing with less capital than traditional real estate, it’s important to consider the risks involved. Do your research to know what you’re getting into with every property.

Don’t forget to check for other liens that the property has against it. If there are other liens, you may be dealing with creditors who also have a claim to the property. This would make it tougher to obtain the title if there’s a foreclosure.

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Tax Lien Investing vs. Tax Deed Investing

Many rookie investors get confused between tax lien investing and tax deed investing. When you invest in a tax lien certificate, you collect your money when the property owner redeems the certificate by paying back the taxes along with the interest and other penalties.

A tax deed sale is when the local government has seized the property because of unpaid taxes. You can purchase the property for pennies on the dollar at a tax deed auction. In this case, you own the deed to an actual property, not just a certificate for unpaid taxes.

In either case, it’s important that you learn about tax sale investing because the local laws vary by state.

Bottom line

Tax lien investing could give you a decent return if you figure out how to do it properly. You also don’t need much money to start tax lien investing. Many REITs will require thousands of dollars, and obtaining a home mortgage comes with a significant down payment that could tie up years worth of saving. Tax lien certificates can be purchased for just a few hundred dollars.

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