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Real estate investing is an effective strategy for diversifying your asset portfolio and building net worth. Fortunately, you don’t have to go through the trouble of owning rental properties to get a high rate of return on real estate—instead, you can try tax lien investing.
Unpaid property taxes present highly profitable opportunities for savvy real estate investors. In this article, we’ll show you how you can benefit from tax liens investing if you reside in one of the 30 states that issue lien certificates to investors.
What Is A Tax Lien?
When property taxes go unpaid, municipal authorities look to investors to foot the bill. Instead of hiring a collections firm to pursue payment from the property owner, the municipality places a lien on the property, which serves as a legal claim against the property for the owed balance.
A tax lien certificate is sold by the city or local authority at auction which reflects the original investment plus a rate of return. The cost of a tax lien ranges from the hundreds to the low thousands depending on the size and location of the property.
Properties with liens attached cannot be refinanced or sold until the lien is removed or the owed amount is paid. The lien holder collects interest on the homeowner’s outstanding debt until the taxes are redeemed on the property.
What To Know Before You Get Started
When sold at auction, investors “bid down” on the lowest acceptable interest rate for the lien certificate. Bidding too low can virtually eliminate the liens’ profit margins and result in the buyer taking a bath on the investment.
On the other hand, tax lien investing can be highly rewarding. If the property owner fails to repay the balance owed plus interest, the lien holder bears the right to foreclose on the property and assume ownership. However, these cases are relatively rare as most property owners pay the required sum before the redemption period expires.
The high-risk, high-reward nature of tax lien investing makes it a hard sell for the novice investor. Although tax liens are viable investments for real estate savvy investors, they encompass responsibilities and obligations that may not be palatable for the unsophisticated.
Before you consider investing in this asset class, you should understand tax lien investing risks and its potential pitfalls. To help you decide whether tax lien investing is right for you, we put together a tax lien investing pros and cons list.
Advantages of Tax Lien Investing
Below-Market Property Acquisition
Where tax lien investing gets interesting is when it serves as a pathway to property ownership for the investor. Tax liens sometimes present an opportunity for investors to own the lien-attached property at a fraction of its market cost.
The tax lien holder can foreclose on the property if the homeowner fails to repay the owed amount during the redemption period, which usually spans between 1 and 3 years.
Equity in the Property
Investing in tax liens might net you a property with a lot of equity in it. Typically, mortgage lenders pay the taxes and insurance each year on the property. However, most of the properties for which tax liens are issued do not have a loan against them.
In many cases, liens-attached properties are inherited assets with tax obligations for which the heir does not have the financial backing to pay.
Fixed Interest Rates
Rather than financial markets, the determiner of your rate of return is the state from whom you’ve purchased the lien. As a lien holder, you benefit from the status of the lien as a guaranteed fixed-rate investment—that is, your interest and capital is guaranteed from the outset regardless of market performance.
Reduce Risk Through Lien Funds
Investment companies offer private placement funds that purchase tax lien certificates. This method diffuses risk by pooling your contribution with other investors’ and can streamline the acquisition process by bidding on your behalf at auctions.
Hands-Off Investing
Unlike other forms of real estate investing, tax liens investing abides by the “set it and forget it” principle. After purchasing the lien, you sit on the investment until the redemption period expires or the debt is repaid with interest.
Drawbacks of Tax Lien Investing
Misfit Properties
Tax liens investing can land you an unwanted property. Be careful not to invest in an undesirable property, such as undeveloped land, or a landlocked sliver of vacant property that’s physically inaccessible. Otherwise, you may be left on the hook for maintaining and cleaning a property that you would rather not have to deal with.
Location Variability
Tax lien investing is very area specific. The rules and regulations that govern the issuance and sale of tax liens vary widely by county and state. Naturally, some areas are going to offer higher rates of return than others.
Upkeep Intensive
Managing your tax lien portfolio is paperwork-intensive and requires the consistent filing of administrative work by state-mandated deadlines. Often, administrative duties are outsourced to a portfolio manager who can eat into your profit margins.
Research Intensive
It takes a concerted research effort to source the best deals on liens-attached real estate. Usually, frequent attendance at tax sale auctions is required to learn where the highest-value properties are being sold and what commonalities are shared between them.
Money Up Front
Tax liens aren’t a “no cash down” type of investment. To invest in tax liens, you’ve got to have the cash upfront to purchase the certificate. Liens on more significant commercial properties can stretch into the six-figure mark, but most residential and undeveloped real estate tax liens are sold in the three or four-figure range.
Wrapping It Up
There’s no one-size-fits-all approach to making money in real estate. Like all forms of alternative real estate investing, the buyer assumes a degree of risk when purchasing tax liens. The upside, however, is that discerning investors can reap rates of return that far exceed that of direct real estate investing—assuming you can avoid the pitfalls of this asset class.
Liam Hunt, M.A., is a financial writer covering global markets, monetary policy, retirement savings, and millennial investing. His commentary and analysis have been featured in the New York Post, Reader's Digest, Fox Business, and Forbes.
