Real estate investment can be lucrative, but what if you don’t have the funds to purchase a property or simply don’t want to be tasked with property management or dealing with tenants?  One way to indirectly invest in real estate is to invest in tax liens attached to properties.

Before you invest, here’s everything you need to know, including how to invest in a tax lien and what they are.

What Are Tax Liens?

Tax liens are the legal repercussions a property owner faces when they fail to meet their property tax obligations. Once a tax lien is issued, the property, such as a home, cannot be sold or refinanced until the debt, plus any fees and interest, is paid. If the debt is not paid, the issuing entity can seize the property.

Tax liens are issued by the city or county where the property is located. The issuing municipality will also create a tax lien certificate, typically auctioned off to investors.

Tax Liens as an Investment

When you invest in tax liens, earnings come from the interest applied to the lien. Tax lien interest is simple interest, as opposed to compound interest. It’s also important to note that interest rates vary by state. For instance, in Iowa, tax liens can accrue 2% per month on the unpaid balance. In Florida, the interest rate on a lien can be as high as 18%.

Not every state allows the transfer of tax liens from the public to the private sector. According to National Tax Lien Association (NTLA) the following states and the District of Columbia allow the sale of tax liens:

Pros and Cons of Tax Lien Investments?

If you’re considering tax lien investments, here are some benefits and drawbacks to keep in mind:

Pros

• Accessible costs – You can invest in a tax lien for as little as a few hundred dollars, meaning they are more accessible than other types of alternative assets, such as real estate or mortgage notes.

• High-yield potential – Depending on the state in which you purchase a tax lien, you may be able to see a rate of return that exceeds many traditional assets, such as bonds. That’s particularly true in states that have more generous rate caps on tax lien transactions.
• Portfolio diversity – Tax liens aren’t linked to market performance, making them a good way to diversify your portfolio. And, since the cost of a lien is generally much lower than other types of alternative assets, you may have the financial bandwidth to purchase more than one or multiple leans across jurisdictions.
• Predictability – You know how much you’ll earn on a tax lien investment, which isn’t the case with market-based investments. Tax liens also have an expiration, so you’ll also know when you can anticipate the earnings.

Cons

• The bidding process can diminish earning potential – Just because a state has a healthy tax lien rate doesn’t mean the earning potential is always there. Investors typically bid on tax liens, and depending on where you mean, that could mean the winning bidder is the one who is willing to purchase the lien for the lowest rate below the state maximum. In other cases, the bid may go to the investor willing to pay the most over the value of the lien. In both scenarios, earning potential can drop during the bidding process.
• The property holder may not pay up – Ideally, the property owner pays off the tax lien, and you’ll receive the sum you paid for the loan plus the applied interest, but that’s not always the case. The property owner could fail to meet payments. That doesn’t mean you’re at a complete loss. You can move forward with the foreclosure process, but that can take time and money.
• You could be investing in a problem property – If the lien goes unpaid, you’ll eventually become the property owner. When the property is in fair to good condition, that may not be much of a problem. However, if the property is in disrepair or has significant environmental damage or issues, such as contaminated groundwater, then offloading and recouping losses can become problematic down the road.

How to Purchase Tax Liens

Choose a location and find an auction

You can purchase a tax lien in 29 states and the District of Columbia. Determine the jurisdiction in which you’d like to purchase a tax lien and familiarize yourself with the rules and auction cycle. Some tax lien auctions are held online, while others are in person. In addition, familiarizing yourself with local tax lien laws can also help you determine how the taxes are collected and when the auctions are held.

Do your due diligence

Like many investments, tax lien investments require due diligence. Make sure you thoroughly research the property before you bid. Be on the lookout for other liens against the property that may make it harder to recoup your investment. In addition, keep an eye out for potential issues, like environmental damage, that may make it hard to sell the property should the lien go unpaid.

Be prepared to pay upfront

When you buy a tax lien, you’re responsible for paying the cash value of the lien plus penalties and fees upfront. That’s because municipalities auction off liens with the primary goal of recouping lost taxes.

How to Purchase Tax Liens with Retirement Funds?

You can purchase a tax lien with regular funds, such as those in your checking or savings account. Tax liens can also be purchased as part of your retirement account savings strategy by using funds from your IRA or 401k, but only under certain circumstances.

You cannot use funds from a standard retirement account, like a traditional or Roth IRA, that can only hold common assets. Instead, you’ll need to open a self-directed account, such as a self-directed IRA (SDIRA).

An SDIRA is a retirement account that is structured similarly to a standard IRA, but it allows you to invest in alternative assets, such as real estate, commodities, promissory notes, and tax liens. To open an SDIRA, you must find a custodian, like Horizon Trust, that offers SDIRA accounts, as most major banks and brokerage firms don’t offer this type of product.

Are Tax Liens a Good Investment?

Tax liens can be a good investment as long as you complete due diligence. They aren’t as costly as investing in actual property, and they offer the potential for higher returns when compared to other common investment assets, and often within a relatively short period, such as three years.

Further, if the property owner fails to meet their payment obligations, you can inherit a property, which can be sold for a profit. However, if the property is undesirable or difficult to sell, or you simply don’t want to deal with the time and money required for the foreclosure process, you may be at a loss. Also, remember that other liens on the property or bankruptcy proceedings can affect your ability to recoup your investment.

To mitigate the risks associated with a tax lien investment, always thoroughly research the property before you place your bid.

FAQs

Are Tax Liens Risky Investments?

Like most investments, there is some risk associated with a tax lien investment. The property owner may fail to pay off the lien, which can result in foreclosure. As the lien holder, you’d be responsible for initiating and following the foreclosure process through.

Further, other liens on the property may make it difficult to proceed with the foreclosure.

To limit risk, always evaluate the opportunity, familiarize yourself with local laws, and assess your risk tolerance.

How Long Can a Tax Lien Last?

Tax liens redemption periods vary by state. To find out how long the redemption period is in your state, contact your local government or visit the Department of Revenue (or similar entity) website.

How Do Tax Liens Differ from Mortgage Liens?

Mortgage liens are held by the lending entity. If a mortgage lien goes unpaid, the lender can take ownership of the property. Tax liens are held by the municipality in which they are issued unless they are purchased by a private investor. If a tax lien goes unpaid, the issuing government entity or individual who purchases the lien can begin foreclosure procedures and take ownership of the property.