What are the Risks of Buying Tax Liens?

Real estate investors don’t always need to buy real estate. Instead, some choose to indirectly invest. For instance, many people invest in real estate tax liens to earn interest income. As such, I’m frequently asked: Ryan, what are the risks of buying tax liens

Most investors buy tax liens to collect the interest payments. They do not want to foreclose on the property. This poses several risks to buying tax liens. Investors could 1) buy liens for a worthless property, 2) face foreclosure issues, 3) be assessed fines, or 4) lose priority in a bankruptcy.

I’ll use this article to cover more of the risks of buying real estate tax liens. Specifically, I’ll cover the following topics:

  • What are Tax Liens?
  • Why Do Investors Buy Tax Liens?
  • What are the Risks of Buying Tax Liens?
  • Final Thoughts

What are Tax Liens?

Prior to talking about the risks of buying tax liens, I need to discuss tax liens in general. And, to discuss tax liens, I need to explain real estate taxes. 

When you own a home, the government charges you a tax to own that home—real estate taxes. First time homebuyers often find themselves surprised by this expense. In addition to principal, interest, and insurance, most mortgage payments include an escrow amount for real estate taxes. In most municipalities, this annual assessment equals a tax-assessed property value multiplied by the local tax rate. For example, assume your county property tax is 1.2%. If the county assessed your home at $200,000, you’d need to pay $2,400 per year ($200,000 x 1.2%) in real estate taxes. However, most municipalities do not charge this as a one-time payment. Instead, you’ll typically pay this on a quarterly or semi-annual basis. 

But, what happens if you don’t pay this tax? Answering this question requires an understanding of the government budgeting process. As they aren’t businesses, local governments project their revenue primarily based on taxes. Accordingly, they look at the properties in their boundaries, project the annual property taxes on those properties, and largely build their operating budgets around these taxes. 

As a result, a failure to pay those taxes disrupts the government’s operations. In other words, if you fail to pay your taxes, the government takes a hit to its ability to pay for daily operations. Recognizing this shortcoming, local governments have implemented a system to recoup funds of property owners who fail to pay their taxes. 

If you’ve gone a designated period and failed to pay your taxes (60-, 90-, 120-days—whatever the local government deems its cutoff point), the government will sell your real estate tax debt. More precisely, they will create a tax lien certificate, which outlines A) the debt you owe, and B) the interest associated with it. Then, they sell these tax lien certificates to investors who seek to collect the interest. 

For the government, this smooths cash flow. When residents fail to pay their taxes, selling tax liens allows the government to pay for its annual operating commitments. For the investors, it offers a way to collect interest. Specifically, when homeowners eventually pay their debts, the government collects the funds, but it then forwards this money—plus interest—to the investor holding the tax lien certificate. 

Alternatively, homeowners never pay their taxes. When this happens, investors have a path to foreclosure. Depending on who else has a lien on the property, investors can potentially foreclose on the property and resell it to profit on their tax lien investment. 

Why Do Investors Buy Tax Liens?

While foreclosure remains an option for tax lien investors, it’s not the primary option. Rather, most investors buy tax liens on properties they don’t want to own. They typically just want to collect the interest payments on the outstanding liens. In theory, tax liens should provide investors a low-risk, high-return investment option. In reality, significant risks exist with this investment strategy. I’ll outline some of the major risks of buying tax liens in the next section. 

What are the Risks of Buying Tax Liens?

Broadly speaking, investors face four major risks when they buy real estate tax liens: 

Property is Worthless

Realistically, many homeowners stop paying their property taxes because their properties are worthless. For example, they may own a landlocked vacant lot, something that could never be developed. Or, a lot could not meet the local municipalities minimum size for building. In certain areas, environmental problems may exist, too. For instance, a septic tank could be out-of-code, requiring thousands of dollars to repair. 

Regardless why, many properties simply end up worthless. As a tax lien investor, you run the risk of purchasing a claim to one of these worthless properties. This means that, if you need to foreclose, you’ll own a property that cannot be sold to recoup your investment. 

Foreclosure-related Risks

Foreclosure also poses a risk in and of itself to tax lien investors. In most municipalities, when you buy a real estate tax lien, the area has a clear statute of limitations for when the lien expires. Unfortunately for investors, foreclosure is not a fast process. If you begin to file the foreclosure paperwork and the owner pays off his or her debt during the process, the municipality extinguishes the lien. In this situation, you’ll typically recover your debt principal, but you may not gain the associated interest on that debt. 

Local Property-related Fines

When you buy a tax lien, you inherently gain a stake in the underlying property. This poses a potential threat when it comes to the condition of that property. Of note, property owners must maintain their properties. If the lawns grows out, paint chips, garbage accumulates, or any other number of problems, the local government can fine the property owner. Eventually, the fines and associated costs can surpass the value of the property. As a result, tax lien investors could eventually foreclose on a property that has local fines outweighing the actual market value. 

Owner Bankruptcy

Lastly, owner bankruptcy poses a major risk to tax lien investors. If a property owner files for bankruptcy, the outstanding tax lien falls under the overall debt umbrella. Unfortunately, this means that the bankruptcy judge can order other debts paid off before the tax lien. Or, the judge could lower the interest rate on your tax lien certificate. Either way, you lose as the investor. You either get no money (if your debt falls low on the creditor priority list), or less money than your initial investment projected (if the judge reduces the interest rate on your tax lien certificate). 

Fortunately, most tax lien investors can preemptively avoid this situation. Many municipalities require bankruptcy disclosure. Accordingly, if a property has already begun bankruptcy proceedings, the government needs to declare this to potential tax lien purchasers. Bottom line, do not purchase a tax lien involved in a pending bankruptcy

Final Thoughts

Tax liens can provide an outstanding passive investment opportunity. However, as with all investments, purchasing tax liens comes with risks. As an investor, it’s critical that you measure these risks against any purchase. Rather than dive headfirst into a tax lien investment, take the time to assess the costs and benefits before purchase. 

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