The Basics of Tax Lien Investing

Tax Lien Certificates Can Diversify an Investment Portfolio

Image shows a certificate. On it reads: "How tax lien certificates work: when a homeowner falls behind on their property taxes, the county or municipality where the property is located can place a tax lien against the property. The lien certificate can then be purchased by an investor in a public auction. Bid winners pay the tax office the amount of taxes owed on the certificate, and then assume the right to collect that money back from the homeowner, along with interest'

The Balance / Emily Roberts

Real estate can be a potentially lucrative investment but owning a rental property can take up a significant amount of time and energy. Investing in tax lien certificates is one alternate way to include real estate in your portfolio without having to don a landlord's cap.

Tax lien investing can be more complicated than owning mutual funds or stocks, however, and it may be better suited to some investors than others. Weighing the risks and rewards of investing in tax liens can help you decide if this real estate investment option belongs in your portfolio. 

What Are Tax Lien Certificates?

Tax lien certificates, also referred to as tax executions, certificates of purchase, and tax sale certificates, represent a form of debt that's tied to real estate.

The National Tax Lien Association (NTLA) describes tax liens as “instruments offered for sale by local county and municipal governments as a method of recovering property tax dollars deemed delinquent due to the property owner's failure to satisfy the debt." 

In other words, when a property owner fails to pay their property taxes, a state or local tax agency can place a lien on the property. This lien prevents the property owner from selling or refinancing the property until they pay the tax debt. 

County and municipal governments create a tax lien certificate that states how much is owed in property taxes, along with any interest or penalties due. These certificates can then go to auction for investors, allowing the governments to collect payment on the past-due taxes, interest, and penalties. 

Tax lien certificates can only transfer ownership of property tax debts, not the property itself. 

How Tax Lien Investing Works

Tax lien investing is real estate investing without the actual ownership of property. Instead, you're investing in debt that's related to that property through a lien. 

If you're interested in tax lien investing, the first step is finding tax liens for sale at auction. Your local tax agency may be able to provide information on when tax lien auctions take place, according to the NTLA. Once you know when a tax lien auction is scheduled, you can plan to attend.

Generally, tax liens are sold to bidders in one of two ways:

  1. By the lowest interest rate bid
  2. The highest cash offer

When you buy a tax lien, you're responsible for paying the outstanding lien amount, plus interest or penalties due. Then, the state or municipality pays you principal and interest when the property owner makes their property tax payment—this is how you earn money with tax lien investing.

Not every state lists tax liens for sale at public auction. 

In most cases, the tax lien has a redemption deadline and a certificate expiration date. The redemption deadline is the amount of time the property owner has to pay the tax debt. The certificate expiration date is the amount of time you have to file a foreclosure action if the property owner doesn’t pay.

For example, in Baltimore, property owners have six months to redeem their property before the lienholder can take foreclosure action. However, that right to foreclose expires two years after the certificate purchase date, at which point the lienholder would have to sell the tax lien in the same manner they bought it: at a public sale or auction.

Benefits and Risks of Investing in Tax Lien Certificates

There are several points that make tax lien certificate investing an attractive prospect.

  • May only need a few hundred dollars to buy the tax lien certificate

  • Can diversify by purchasing certificates for a variety of properties and locations

  • Consistent rate of return

  • Homeowners could choose not pay if property’s market value is worth less than taxes due

  • Homeowner might not to redeem the property, regardless of its value

  • If lien expires, you won’t be able to collect any unpaid taxes; your rights as a lienholder expire too

Benefits Explained

First, these investments often have a low threshold for buying in. You may be able to purchase tax lien certificates at auction with just a few hundred dollars. Buying a rental property, on the other hand, may require taking on a mortgage. And even real estate investment trusts (REITs) can require several thousand dollars to buy in. 

A smaller initial investment makes it possible to spread capital across multiple tax lien certificates. This allows you to diversify within the real estate asset class by purchasing certificates located in different housing markets or certificates for commercial properties in addition to residential ones. 

From an earnings perspective, you get a consistent rate of return. With tax lien certificates, returns are based on the interest rate the property owner pays you. If you hold a tax lien certificate in a state with a higher maximum interest rate, your investment could yield a substantial payoff. 

For example, Florida's maximum interest rate is set at 18% while Arizona's maximum rate tops out at 16%. Either one could help you earn more than you might in a fund that tracks an index like the S&P 500, depending on the condition of the stock market.

Tax lien certificate interest rates are applied using a simple interest formula, rather than compound interest

Risks Explained

Like any other investment, tax lien certificates do carry certain risks. 

One big one to watch out for is buying tax lien certificates for properties whose market value is less than the amount of taxes due. In that scenario, the homeowner may not have much motivation to pay what's owed. 

There's also the inherent risk that the homeowner won't redeem the property, regardless of its value. A foreclosure could allow you to take ownership of the property but the legal fees can be expensive. If that were to happen, you may also face additional costs to repair or rehab the home once you take ownership. Foreclosing can also be problematic if there are other liens or claims in place that need to be cleared before you can assume the title. 

Tax liens typically have an expiration date that falls after the end of the redemption period. If your lien expires, you wouldn't be able to collect any unpaid taxes because your rights as a lienholder expire along with it. You'd have to purchase any subsequent liens to maintain your rights; otherwise, another investor could make a claim against the property. That increases your overall investment.

Before Investing in Tax Lien Certificates

Due diligence is critical for managing risk with tax-lien certificate investing. Before diving in, take time to familiarize yourself with:

  • State laws regarding tax lien certificates
  • What your responsibilities are for notifying the homeowner that you've purchased a lien
  • Maximum interest rates assigned to tax lien certificates
  • What type of property you're most interested in investing in

Some states make information about tax lien certificates and their associated properties available before public sale or auction. Take time to review the details of both before offering a bid. 

Finally, consider how much money you're willing to invest in tax lien certificates and your personal risk tolerance. While tax-lien certificate investing can offer potentially higher rewards than other real estate investments, it can introduce additional risk into your portfolio. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.