Not all real estate investors buy properties. Some choose to focus on investing in items related to real estate—like tax liens. I frequently get the following request: Ryan, can you tell me how to buy real estate tax liens?
If a homeowner fails to pay property taxes, the local tax authority can place a lien on the home. Governments sell these liens to investors. When the homeowner pays the taxes and interest, the government collects the money and pays the investor.
So let’s discuss how real estate taxes (and liens) work, how to get started buying tax liens, and a few tips for successful investing in tax lien properties.
AN OVERVIEW OF REAL ESTATE TAXES
To understand buying real estate tax liens, investors must first understand tax liens themselves. To raise money, governments need to tax residents. You’ll likely understand just how much you’re taxed if you’ve ever looked at a pay stub. However, whereas the federal government and most states tax income, local municipalities (towns, villages, cities, counties, etc.) derive a large portion of their revenue by taxing property.
With property taxes, local governments employ assessors to determine the value of your real estate. Then based on that tax-assessed value, they charge you an annual real estate tax. Typically, governments collect these annual amounts on a quarterly or semiannual basis. For example, assume the tax assessor values your home at $200,000. If your municipality has a 1.2% property tax rate, you’d owe $2,400 in annual taxes ($200,000 x 1.2%). In a quarterly system, you’d then pay $600 four times throughout the year.
Many homeowners do not understand real estate taxes because their lender pays them from escrow. With most mortgage payments, you pay loan principal and interest—and some money earmarked for real estate taxes into an escrow account. Then, the lender pays them directly to your local tax collector whenever those taxes are due.
This system creates an environment where many homeowners don’t understand the property tax assessment and collection process. And, through either A) lack of understanding or B) inability to pay, property owners sometimes fail to pay these taxes. When this happens, municipalities send a variety of notices. This differs in each locality, but tax collectors typically send 30-day, 90-day, and 6-month notices of past-due payments.
WHY GOVERNMENTS SELL REAL ESTATE TAX LIENS
Eventually, local governments need the money from these tax bills to operate. Governments build their budgets based on projected revenues, and property taxes comprise a large portion of a local municipality’s annual revenue. As a result, if a homeowner fails to pay property taxes after several collection attempts, governments sell the tax debt to investors.
They do this by creating and selling tax liens. These sales A) provide governments funds to meet their operating commitments, and B) provide investors an alternative investment opportunity.
A lien serves as a legal claim against some property. Governments impose a legal claim against some real estate with tax liens due to the owner’s failure to pay the associated property tax bills. For example, assume that a homeowner has failed to pay a $2,500 property tax bill and hasn’t responded to any collections notices. Eventually, the government imposes a lien for this unpaid amount (and, likely, penalties and interest). When a property has a tax lien, the owner cannot sell or refinance the property until paying the outstanding balance.
When an investor purchases a tax lien, the taxpayer eventually needs to pay them the balance of the debt plus any accrued penalties and interest. However, taxpayers remit payments to the government, and then the government pays the investor.
HOW TO BUY REAL ESTATE TAX LIENS
It seems like a pretty good system—I buy tax debt, but the government collects the payments for me? In a nutshell, yes, that’s how investing in tax liens works. More complications exist—which I’ll address below—but I’ll first outline how to buy real estate tax liens.
When a municipality imposes a tax lien, it creates an associated tax lien certificate. This certificate outlines the amount of tax due plus any related interest and/or penalties. Depending on the size of the property, these liens could cost anywhere from a few hundred dollars to hundreds of thousands of dollars.
These tax sales provide opportunities to buy real estate tax liens. They can be online or in-person. Every municipality handles these sales. Some governments hold standard auctions, while others have investors bid down interest rates.
HOW INVESTORS MAKE MONEY WITH REAL ESTATE TAX LIENS
I touched on it above, but investors generally make money in one of two ways to purchase real estate tax liens.
The first—and ideal option for most investors—involves the taxpayers actually paying the past due taxes. Once investors purchase a tax lien certificate, they become entitled to the tax amount plus any interest and penalties. If the taxpayer eventually makes those payments, the government will collect the funds and then remit them directly to the tax lien certificate holder. Frequently, this occurs when the owner tries to sell the property and cannot do so until paying off the lien. Interest and penalties vary by municipality, but they can add up to a significant return for investors with a large tax lien.
In most municipalities, if an investor purchases a tax lien for a given year’s taxes, they have the option to buy subsequent years’ tax liens for that same property. Eventually, the investor can foreclose on the property to recoup these funds. Most investors want to avoid this second option.
Most investors don’t want this outcome, as the underlying properties typically have significant problems (which is why many homeowners don’t pay taxes in the first place). Fortunately, though, it doesn’t often reach this point. Instead, the lender will generally pay off your lien if a property has an outstanding loan. This lets you profit on the deal without going through with foreclosing on and taking possession of a distressed property. Real estate tax lien investors tend not to want the hassle of rehabbing and selling a property. They just want to collect the interest and penalties associated with the tax lien.
Conceptually, investing in real estate tax liens is a fairly straightforward process. You pay someone else’s taxes, they owe you this money plus interest, and the government collects for you. If the homeowner fails to pay the taxes, you can either foreclose and recoup funds or get paid off by the lender.
Real estate investors can make a significant amount of money investing in tax liens. But this strategy involves risk, too. You may end up with a property on your hands that you never wanted, without the ability to recoup your entire investment. But, if you are willing to assume this risk, your local tax authority can provide you with details on how and when its tax sales occur.