What to Know About Tax Lien Certificates

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'

Image by Emily Roberts © The Balance 2019

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 an alternate way to include real estate in your portfolio without having to don a landlord's cap. Tax lien certificate investing can be more complicated than owning mutual funds or stocks, however, and it may be better suited to some investors than others. 

Tax Lien Certificates Defined

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. A tax lien certificate is issued (typically by the tax assessor's office) verifying that there's a lien in place and the amount of taxes owed. According to the National Tax Lien Association, an estimated $14 billion in property taxes go unpaid each, year creating a broad market for investors. 

Tax Lien Certificates as an Investment Vehicle

When a property has a tax lien, it can't be sold or refinanced until the past due taxes are paid. The lien certificate itself, however, can be purchased by an investor. This typically occurs through public auctions organized and held by the county or municipal tax collector's office. Auctions can be held in-person or online, with certificates going to the highest bidders.

If you bid and win, you pay the tax office the amount of taxes owed on the certificate. You then assume the right to collect that money back from the homeowner, along with interest. The maximum interest rate you can collect varies, based on the state the lien is in. In Florida, for example, the maximum rate is 18 percent while it in Iowa, it's just 2 percent. In some states, it can climb as high as 36 percent. 

The homeowner has a certain amount of time to redeem the debt and pay what's owed. Again, this depends on the state in question, but the redemption period may range from six to 36 months. If the owner doesn't pay the taxes and interest due within the redemption window, you would technically have the right to foreclose on the property

Benefits of Investing in Tax Lien Certificates

There are several points that make tax lien certificates an attractive investment. 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. That's a smaller outlay of capital compared to certain mutual funds, which may have a $5,000 or $10,000 minimum to buy shares. 

A smaller initial investment also 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. Finding auctions too big usually isn't difficult, either. You can simply contact the tax assessor for the county where you want to bid on certificates to find out when the next auction is scheduled. 

Perhaps, more importantly, from an investment perspective is the opportunity to earn a consistent rate of return. With stocks and mutual funds, returns are determined by movements in the market. With tax lien certificates, returns are shaped by the interest rate that's paid to you. If you hold a tax lien certificate in a state with a higher maximum interest rate, your investment could yield a substantial payoff. 

Tax Lien Certificates Aren't Risk-Free

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. 

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. 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 lien holder 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. 

Due Diligence Is Critical

If you're considering investing in tax lien certificates, you can't afford to skimp on research. You need to understand what the state laws are regarding tax lien certificates, including the length of the redemption period, what your responsibilities are for notifying the homeowner that you've purchased the lien certificate and the maximum interest rate allowed.

You should also research the specific market you're interested in to understand how much tax lien certificates typically sell for at auction and how much competition you may face from other investors. Finally, consider your larger investment strategy to determine what gap or need tax lien certificates could help to fill. Knowing what you're investing in is one part of the puzzle; you also need to understand the "why" behind it.