Intermediate

Advantages and Disadvantages of Tax Lien Investing

Tax lien investing can be a lucrative option for those looking to get into real estate investing without actually having to buy a property. There are also quite a few risks to contend with, as well as rewards.

It’s a relatively passive form of investing, although there’s a bit of legwork involved and tax lien investors do have specific responsibilities to carry out.

In this article, find out exactly what tax lien investing is and how it works, and get the low down on the advantages and disadvantages of purchasing tax liens as an investment strategy. You’ll also learn where to buy tax liens and about other ways to invest in real estate too.

What is tax lien investing?

When property owners or landowners don’t pay their property taxes, a local county or municipal government places a legal claim on their property through a tax lien, which means the property can’t be sold or refinanced until the debt is paid and the lien is removed.

Tax liens are sometimes sold off at auction to investors, so the local government can quickly recoup these costs.

Investors effectively pay the property tax bill, in return for the right to get their money back, plus interest from the property owner. And, if the owner fails to pay back those taxes within a set redemption period (typically between one to three years), the investor may be able to initiate foreclosure proceedings to take ownership of the property.

Like regular auctions, there is a bidding process involved. In this case, the investor who is willing to accept the lowest amount of interest, or pay the highest premium on the lien, wins the auction and gets to purchase the tax lien. Bidding wars are common.

Real estate investors who buy tax liens at auction are issued with a tax lien certificate from the county or city in which the property/land is located. Tax liens can cost anywhere between a few hundred dollars to thousands of dollars to buy.

The rules and criteria around purchasing tax liens vary by jurisdiction or state, and not all states allow the selling of tax liens. Interest rates are one of the factors that differ. For example, in Iowa, the statutory interest rate is 2% monthly, but in Alabama, it’s 12% fixed.

The risks involved with tax lien investing

Purchasing a tax lien on worthless property

One of the most significant risks of tax lien investing is getting stuck with property or piece of land that the current owner doesn’t even want, and so is quite willing to have the city take it back, rather than shell out property taxes.

This can happen if property is left as part of an inheritance, but the owner is unable to sell or develop it due to certain restrictions. Or perhaps it’s a piece of swampland, or simply a slither of land that’s too small to do anything with. 

If you’re thinking about purchasing a tax lien, it’s crucial to do your homework beforehand to make sure you fully understand the property you’re dealing with.

When the property is in a poor state of repair

Tax lien investments are “locked in” for the duration of the redemption period. Even if you’ve done plenty of research and are happy that the property will yield an excellent rate of return should you come to own it eventually, a lot can happen during that time.

For example, the existing owner, having accepted that they’re not able or willing to pay their taxes, could decide not to bother carrying out maintenance or repairs on the property and effectively let it crumble to the ground.

Not a liquid investment

Because tax liens are locked in for a certain amount of time, this means that you’ll have to wait a while before you can do anything at all with your investment.

Bankruptcy issues can impact tax liens

If the property owner or landowner declares bankruptcy while they own the property, this could potentially delay or hinder your investment. You may not get the full amount of interest you were expecting or find that you have to wait even longer to get your money back. The amount you’ll get lies in the hands of the bankruptcy court.

Competition and bidding wars

It’s not just private real estate investors who are interested in tax liens; banks and hedge funds are too. These institutions have money – a lot of it. This means they can outbid individual investors and drive down yields, so there may not be as many profitable tax liens around to take advantage of. 

If you’re bidding against the banks, investing in tax liens may be no more profitable than if you tucked your money away in a savings account.

The advantages of tax lien investing

Decent interest rates are possible

On the other hand, it’s entirely possible for tax liens to be a lucrative investment, providing you don’t get sucked into a bidding war and you’re prepared to wait for the right opportunity to come along. 

We’ve touched on some of the statutory interest rates offered by individual states earlier in this article, but they can be as high as 36% annually, which is the case in Illinois! Moreover, you’ll get a guaranteed interest rate. The rate you get at purchase is what you can expect when you collect the taxes from the landowner/property owner. 

Low capital requirement

Though tax lien investing is perhaps better suited to experienced investors, it’s possible to jump into this asset class for just a few hundred dollars to start with. If you want to diversify your portfolio, this is an easy way to do it.

More of a “hands-off” investment

There’s clearly much work you need to put in at the beginning of the process in terms of research, and in keeping a close eye on your portfolio during the duration of the tax lien. However, it’s a real estate investment strategy that requires much less effort than flipping properties, for example, or becoming a landlord.

Tax lien funds

For a more passive and hassle-free approach to tax lien investing, you can purchase them through a tax lien investment company, and take advantage of their knowledge and experience, while achieving a healthy return.

Possible foreclosure proceedings

Should the owner fail to pay the property taxes while you own the tax lien, you may be able to start foreclosure proceedings and buy the property itself, for less than the market value. 

With that said, the National Tax Lien Association (NTLA) has reported that most property taxes are paid before the tax lien expires, so the possibilities of this happening are somewhat slim.

Possible equity

Typically, where there’s a mortgage on a property, the property taxes are getting paid. This is because lenders often roll property tax fees into a borrower’s monthly payments. So if property taxes aren’t being paid, the chances are there’s no loan on the property.

For you, as an investor, this is good news, as it means that there’s likely to be equity in the property. If you are able to foreclose and take ownership of the property, your investment could get a significant boost.

Where and how to buy tax liens

Considering that interest rates vary by state, you’ll want to do some research and decide which area(s) to focus on when investing, what type of property you want to buy a tax lien on (e.g., residential or commercial) and then check out the real estate laws in that area so that you’re fully prepared.

For example, find out whether there are any legal rules that you need to adhere to when collecting payment from the landowner/property owner and learn about foreclosure laws within the state where you intend to invest.

You can get hold of a list of tax liens from the local county registrar’s office. Find out exactly which states sell tax liens here. Listings may be updated frequently, or just once per year, depending on the state in question.

Auctions may be held online or at a physical location. Be sure to ask how the auction will work, e.g., whether you’ll be required to bid down the rate of interest or bid up the starting price of the lien.

It’s also worth asking whether there are any unsold liens left over from the last auction that may be offered for sale early. You may be able to get a better deal this way, but often tax liens remain unsold for a reason – they may be a bad investment!

Other ways to invest in real estate

If you decide investing in tax liens isn’t for you, but you still want to get into real estate without buying property, there are several options to explore. For a low-cost, liquid investment, you could put your money into an exchange-traded fund (ETF) that offers you exposure to real estate asset classes.

You can do this through a real estate investment trust (REIT) that invests in several real estate companies that own different types of properties.

Alternatively, you could invest in real estate mutual funds, in a real-estate focused company, or real estate notes (a promissory note which describes the loan a buyer needs to purchase a home and which acts as collateral should the buyer fail to repay).

A new investing platform worth checking out is DashVest. It allows you to expand your reach and diversify your portfolio through balanced real estate investment funds. The app provides access to the type of deals that are typically only available to seasoned investors and banks.

A key feature within DashVest is its investor profile wizard, which can create a personalized portfolio for you based on your goals and life plans. Early access to the app is now available.

Top takeaways

This article has covered some of the risk factors and benefits that you can expect when investing in tax liens. It’s a strategy more suited to experienced real estate investors, who fully understand the risks and can mitigate them by having sound knowledge of the local area and knowing what to look for. Access to experts such as a tax attorney who can advise on the legal implications of tax liens would be highly beneficial.

Although you can get started with tax lien investing with just a few hundred dollars, you will need a decent amount of money upfront to be in with a chance of getting ahead of the competition to purchase tax liens on profitable properties.

For more information about tax lien investing, including what rights you’d have as the purchaser of a tax lien certificate, check out the NTLA website.