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What is Tax Lien Investing?

Written by a TurboTax Expert • Reviewed by a TurboTax CPAUpdated for Tax Year 2024 • October 16, 2024 1:32 AM
OVERVIEW

If you're a new investor, it pays to explore all of your options. Learn how investing in a tax lien works, how this process is carried out, and what kind of returns it might provide.

Key Takeaways

  • Tax lien investing is an accessible option for individuals looking to diversify their investment portfolios.
  • Tax liens are placed on individuals or businesses that fail to pay property taxes.
  • You can purchase tax lien certificates at public auctions and may be rewarded with interest payments as property owners repay the debt over time.
  • Tax lien investments can be risky, as some homeowners may be unable to repay their debts or file for bankruptcy.

Tax lien investing

You may have thought that investing in real estate is beyond your financial means, but it could be more achievable than you thought. There are countless ways to invest in real estate, and tax lien investing is one of the most accessible options. Although this won't be the best path forward for every investor, individuals looking to diversify their investment portfolios may want to consider investing in tax liens.

What is tax lien investing?

A lien is a legal claim against an asset that is established when a property owner fails to pay the tax debts associated with that asset. In real estate, tax liens are placed upon individuals or businesses that fail to pay property taxes. The landowner or homeowner can typically only remove a property tax lien before its expiration if they repay the debt, along with any penalties and interest.

Property tax liens are initially placed on taxpayers by the local government, including a town, city, or county. While many governments retain rights to collect the tax debt themselves, demand has grown for tax lien certificates. Buying one of these certificates, usually at a public auction, means you take the responsibility for paying the municipality the taxes it's owed. You also assume the responsibility of collecting that debt from the property owner.

By selling a tax lien certificate to a third-party investor, the municipality receives a guaranteed payment for the late taxes, and investors willing to accept the risk will be rewarded with interest payments as property owners repay that debt over time.

Purchasing a tax debt

Prior to holding a public auction where tax liens will be sold, municipalities will publish the liens that will be for sale. This gives interested parties time to review the debt and research the properties before the auction starts. Some of these certificates represent relatively small amounts of unpaid property taxes — a few hundred dollars — but others represent a larger percentage of the underlying property's value. Some certificates that represent large values come with the indication that failure to repay the debt would result in foreclosure on the property.

There are two primary methods to auction off tax lien certificates:

  1. Accept a premium

Municipalities will set a price for their tax liens — which is typically the balance of the late, unpaid debt — and investors can bid any amount above that starting bid. Their return on investment will be the amount they collect from the property owner, in interest, that exceeds their bid.

  1. Accept the lowest interest rate

Following the "bid-down" method, potential investors will compete to bid the lowest stated interest rate on the tax lien. The winning bid will establish the interest rate that the investor receives from the property owner as they repay their debt.

TurboTax Tip:

Before investing in a tax lien, you should research your local laws and ask questions about the property, records, and market.

Tax lien investments can be risky

Many property owners will repay their debts in a timely fashion, following the initial debt repayment schedule. In these instances, investors will profit off the interest portion they collect that exceeds the price they paid for the debt at auction.

But, some homeowners will be unable to repay their debts or will file for bankruptcy. In these cases, investors may be able to recoup their investment in foreclosure proceedings. If their lien is significant enough, they may even be awarded rights to the property itself.

Property acquired through foreclosure will pose its own set of problems (for example, it can be costly to renovate, or it can be difficult to enforce an eviction), but investors may still see a positive rate of return, or make money, when taxpayers fail to satisfy their debts.

Because the outcomes of the debt repayment can vary wildly, tax liens are notoriously risky investments. You should perform sufficient due diligence by researching your local laws before investing in this option.

Questions to ask before investing in a tax lien

Each jurisdiction is unique, so research your state's tax lien laws before you decide to invest. Ask yourself the following questions:

  • The property
    • When was the property last valued?
    • Has the condition of the property changed since its most recent valuation?
    • Where is the property located?
    • Is there a chance the demand for property in this location will change?
    • Is the property located in an area where foreclosures are common?
    • What other liens are on the property?
  • The records
    • Were all procedural requirements followed when the lien was established?
    • Have there been partial payments on the outstanding debt?
    • What is the length of the redemption period?
    • What is the maximum interest rate permitted by the state?
  • The market
    • What is the current market rate of return for tax liens?
    • How familiar am I with the housing market in this area?
    • What does my competition look like, and how much experience do they have investing in tax liens?

If the responsibility of researching liens and taking on tax debt isn’t for you, you may be able to invest through tax lien investment funds instead.

Passive investment

An investment fund is simply a collection of assets that multiple investors can buy into. Though they may not be as common as mutual funds or index funds, there are funds composed solely of property tax debt.

The fund manager researches investment options on behalf of the investors and selects which liens to purchase. The fund manager is also the one to file the required paperwork, track the redemption period of each lien, and inform property owners of repayment schedules.

Because individual investors are paying for somebody else to carry out administrative tasks, their potential return will be smaller than if they ventured out on their own. Investing in such a fund offers the benefits of diversifying your investments without the high costs associated with purchasing your own variety of tax liens.

Investors who want to dip their toes into the real estate market may find success by starting with tax lien investing. If you're familiar with the risks and understand the tax consequences of this investment, tax lien investing may be just the thing to bring into your portfolio.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

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