Given the instability of the current housing market, it is not surprising to find many people jumping ship and searching for new platforms in which to invest. With the economic crisis hitting everyone in their pockets, a real estate investment scheme that began gaining popularity was that of “flipping” houses. This is to buy derelict houses for a very low price and remodeling to sell them for a higher price. The reason it became popular was that houses in some states were being sold cheaply because of either banks or the government foreclosing on the property; thus, people began to buy these homes at auctions only to remodel them and sell them again.
Despite the clever scheme, the business of “flipping” houses did not escape the economic crisis, and it was not long before the risk became too great. However, this scheme gave rise to what has been called “vulture investment,” that is obtaining a profit from buying securities from “distressed entities.” This name, along with the definition and the actions of a few hedge funds have given this sort of investment a bad reputation.
Tax lien investing has been categorized as a type of vulture investment, this is in many ways incorrect since the investor does not benefit from the “distressed” party any more than the government would have benefited, there is no “abuse” that characterizes vulture investments. In many ways, tax lien investing is an evolution from the house flipping investment scheme.
Despite being quite a low risk, tax lien investing is not “easy” and doing it right implies doing research and commitment to avoid experiencing unnecessary losses. These strategies were allowing a potential tax lien investor to avoid the risks involved in this kind of enterprise.
What is Tax Lien Investing?
Before going into the salient points of tax lien investing and the strategies to avoid risks, it is important to understand what a tax lien is, what it is for, and why it is possible to invest in them.
A tax lien is a lien imposed upon a property by the city or county authorities where the property is located to secure the payment of taxes. A tax lien can be imposed for delinquent taxes owed on personal property, real property or as a result of failing to pay income taxes. When a landowner fails to pay the taxes and a lien is attached to their property, they cannot sell or refinance said property until the totality of the taxes are paid, which allows the lien to be removed.
The reason it is possible to invest in tax liens is that when a lien is issued, the governing body produces a tax lien certificate. This reflects the amount of money that it is owed on the property as well as any interest or penalties due; just as properties can be bought and sold in auctions, tax lien certificates can be purchased in this same manner. A private purchase such as this is beneficial to the local government since they can obtain the tax money owed to them immediately and will not have to pursue further action.
The auctions for tax lien certificates are based on the interest rate and a premium, which makes them very different from regular real estate auctions. The tax lien certificate will go to the person who accepts the lowest interest rate or pay the highest premium; this scheme makes bidding wars useless since the more bids there are, the less return rate will be available to the winner. So, the first advice on offer is: Don’t get into bidding wars, they will lose you money.
Typically, once the lien has been bought, the investor is required to pay the total amount of the lien back to the governing body. The investor then notifies the owner of the property that they are the lien holder and it is then that the real investment starts. The property owner will have to pay the investor the full price of the lien plus interest (which ranges anywhere from 5% to 30% depending on the state), if a premium was paid by the investor then, in some instances, this could be added to the amount that must be repaid. The repayment schedule is negotiated and typically lasts from six months and up to three years. Should the owner be unable to pay by the agreed upon deadline then the investor may foreclose on the property, though it is rare that it happens.
Though tax lien investment is widely regarded as a low-risk investment, any potential investor should be aware of the risks involved and the fact that the basic way to avoid losing money is to do research. This means that a smart investor will know the particulars of tax liens in their state, as well as the regulations involved, so far so obvious but what many people do not realize is that it is important to also look into the kind of property the tax lien is attached. Analyzing the property just as one analysis a real estate property is the best way to avoid getting stuck with an undesirable piece of land that will produce no profits.
Looking into the property also means looking into the owner and whether or not they will be able to meet the deadlines, it has been known to happen that there are several liens attached to a property and when it goes into foreclosure the lien holder will be unable to obtain the title of the property. Before acquiring the lien, the investor should know the property as intimately as if they were buying the property itself.
Three Ways of Profiting
It is important that before acquiring a tax lien, the investor is clear on what the strategy is, this means knowing what the endgame will be. And yes, it needs to be a little more elaborate than “getting money”. Whichever strategy the investor chooses, it will have to be one that is well suited not only to the endgame but also to the state law; for instance, if the endgame is to obtain interest income then the best way to achieve that is to choose a state that pays a high-interest rate. If the endgame is to own the property then choosing a state with a short or no redemption period is the way forward.
#1. Buy and Hold
This strategy will allow the investor to profit from the interest of the tax. Buying and holding means that the investor will let the interest accumulate until the owner redeems the lien or the investor chooses to foreclose. It is important that the investor is ready to foreclose a property. Otherwise, the money invested will be a waste.
#2. Assignment Strategy
The endgame here is to profit from tax lien investing and do it as quickly as possible. In this strategy, the investor buys a tax lien and then re-sells it on a secondary market. This reduces the risks involved in foreclosures and allows the investor to pull out their money fast. It needs to be noted that not all states allow for tax liens to be resold.
#3. Foreclosure Strategy
In this strategy, the endgame is to get the property. It is perhaps the riskiest strategy and will necessitate extensive research on the investor’s part. Such a strategy will work best in states that have short waiting periods to start the foreclosure proceedings or, as we mentioned earlier, with no redemption periods. Remember that in some states, holding the tax lien does not immediately make the investor the owner of the property, in some states, an auction has to take place for the ownership of the property.
All of this can be summarized thus:
- Patience is key: Don’t get into bidding wars.
- Research is vital: Know the property, know the law.
- Know the strategy: Determine the endgame and work towards it.
- Know the limit: Tax liens are not permanent, nor is your ownership of them.
- Follow through: You know the limit, be prepared to reach it and act on the consequences.
There is no such a thing as a risk-free investment but, as we have seen, there are strategies that allow a potential investor to minimize these risks and have a more profitable transaction. Tax lien investing may not be for amateurs but it is not only for professionals.