Venturing into tax lien investing opens the doors to real estate exposure without direct ownership of property. Yet, experts warn that the process can be intricate, and novices may be vulnerable to missteps. This comprehensive guide provides you with essential insights into tax liability certificates, covering the mechanics and inherent risks involved.
What is a tax lien?
A tax lien serves as a legal claim imposed by the local or municipal authorities on a property when its owner defaults on property tax payments. This preliminary action precedes more stringent measures such as tax levies, wherein the Internal Revenue Service (IRS) or local government can seize the property to recover the debt.
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| Tax Lien Investments |
Understanding tax lien certificates
Tax liens certificates are generated when property owners fail to remit their taxes, leading the local government to issue tax liens. These certificates detail the outstanding taxes, together with any accrued interest and penalties. Subsequently, these certificates are auctioned off to profit-looking investors.
Delving into the mechanics of tax lien investments
Municipalities, in a bid to reclaim the delinquent tax funds, provide tax lien certificates to private investors who then pay the tax bill. In return, they gain the right to collect the entire amount along with interest from the owner of the property upon payment.
Presently, 29 states, along with Washington, D.C., authorize the transfer or assignment of delinquent real estate tax liens to private entities, as verified by the National Tax Lien Association. The process differs slightly from one municipality to another. Potential investors are encouraged to familiarize themselves with their local area's tax collection procedures by engaging with tax officials.
Auctions can either happen online or in person, with winning bids going to those willing to pay the lowest interest rate—an approach called "bidding down the interest rate." Alternatively, the higher cash bid, or premium, above the lien amount can also secure victory. However, as interest rates decline, so do the potential earnings.
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| tax lien certificate |
The winning bidder pays the balance and handles foreclosure proceedings
The process after winning a tax lien certificate is not akin to stock exchange operations. The winning bidder must remit the entire tax bill, covering delinquent debt, interest, and penalties. Following this, the investor must await the property owner's refund of the entire balance, unless, of course, they fail to do so.
Most homeowners are granted a "redemption period"--generally lasting one to three years--during which they must settle the taxes along with interest in full. However, if the property owner fails to redeem the tax debt, the tax lien investor assumes the responsibility of initiating the forecast process, potentially acquiring ownership of the property.
In certain instances, such as in Illinois, notifying the property owners of the lien's possession and the possibility of foreclosure is mandatory within four months of buying a lien. Subsequently, another notification is required before the redemption period expires.
Assessing the benefits and hazards of tax lien investing
Before plunging into tax lien investing, experts advocate for a comprehensive evaluation of the potential risks involved. While some investors may reap significant rewards, others might be ensnared in a labyrinth of intricate regulations and loopholes, culminating in considerable losses.
- Tax liens can produce higher returns, but not invariably
The profitability of tax lien investments frequently hinges on the interest rate attached to the tax lien. Interest rates fluctuate according to jurisdiction or state laws. For instance, Arizona sets a maximum statutory interest rate of 16 percent, while Florida's is 18 percent, and Alabama fixes the rate at 12 percent, according to the National Tax Lien Association.
Richard Rampell, the former CEO of Rampell & Rampell, an accounting firm in Palm Beach, Florida, recounts his firsthand experience of witnessing institutional investors—including banks, hedge funds, and pension funds—chasing higher yields in auctions nationwide. Hence, these larger investors reduced interest rates, which diminished Rampell's group's profits.
“In the end, we weren't doing much better than a CD,” he laments. "For the amount of work, it wasn't worth it."
- Tax liens come with an expiration date
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| Tax liens come with an expiration date |
If property owners fail to remit property taxes by the redemption period's end, the lienholder can institute foreclosure proceedings to acquire ownership of the property. However, such occurrences are rare, as taxes are usually settled before the redemption date. Furthermore, liens receive priority repayment status, even surpassing mortgages.
Yet, tax liens themselves possess an expiration date, and the lienholders' rights to foreclose or reclaim their investment terminate concurrently with the lien's expiration.
Furthermore, lienholders may find it necessary to pay subsequent property taxes in the following years to preclude others from purchasing a lien and thus laying a claim to the property.
“Sometimes it’s six months after the redemption period,” asserts Joanne Musa, a tax lien investment consultant and the founder of TaxLienLady.com. Don't think you can just buy it and forget about it.
- Tax lien investing in meticulous demands research
Potential investors are encouraged to undertake comprehensive research before venturing into tax lien investments. Experts recommend driving clear of properties with environmental damage, such as those with hazardous materials dumped by gas stations. The presence of such damage would translate to assuming ownership of the property if foreclosure was to occur.
"You should really understand what you're purchasing," advises Richard Zimmerman, a partner at Berdon LLP, an accounting firm in New York City. "Be aware of the property's nature, its neighborhood, and its value, so you don't end up buying a lien you can't collect on."
Prospective investors should investigate the property and any existing liens, along with recent sales tax and sales prices of similar properties. The presence of additional liens could complicate the process of acquiring property title in the event of a forecast.
However, it is important to note that information gleaned from research can often be outdated.
People get a list of properties and conduct due diligence weeks before a sale. Musa warns. "Half the properties on the list may be gone because the taxes get paid. You're wasting your time. The closer to the date you do your due diligence, the better. You need to obtain an updated list."