On the blog I talk a lot about real estate investing. The truth is, real estate is where my skills and interests lie. What I don’t share is this:
Solely investing in real estate is a very dangerous game.
They say, “don’t put all your eggs in one basket.” So true. Investors will always tell you to diversify your investments over different asset classes. That way, if one investment goes kaput, you still have income from the others to keep you afloat.
That’s why I’ve recently been looking into other sorts of investments. Sure, there are the garden variety asset classes like stocks, bonds etc. But I’ve also been interested in a few alternative investments.
Today, I’m gunna talk about a wacky little investment strategy that’s a bit off the beaten path – investing in tax liens. Kind of related to real estate, but then again not really. Let’s jump into it!
What is a property tax lien?
If you’ve ever owed money to the IRS/state, then you have tax debt. Fail to pay your tax debt, and over time the state will escalate their collection methods. One of those hard nosed methods is by putting a tax lien on your property.
When the state puts a tax lien on your property, they’re basically telling everyone,
“Hey, back off. If this tax payer can’t pay their tax debt, then I have the right to seize their property.”
Basically, it’s a legal claim against your home or property.
This method is not unique to the IRS/state, many lenders place liens on your home to protect their interest as well. It’s just that the state usually gets priority over everyone else (meaning that if your property is liquidated, the proceeds go to paying the tax debt first.)
So what is investing in a tax lien about?
Of course, getting a tax lien is unfortunate for the taxpayer. But for you, it’s an opportunity to invest in profitable asset class!
When you invest in a tax lien, you’re buying out the taxing authority’s claim against the property. You may pay more or less than the face value of the tax lien (face value = tax debt owed + accumulated interest + accumulated penalties).
Once you buy the tax lien, you have a right to collect the tax debt, interest and penalties from the taxpayer.
Why should you invest in tax liens?
Super high yield compared to traditional investments – interest rates are coming down and typical fixed-income investments like bank certificates and 10-year treasury bonds offer between 1.5 – 2.0% yield. In comparison, investing in a tax lien could net you a whopping 15 – 35% yield. ‘Nuff said!
Surprisingly safe investment – It sounds sketchy but it’s true. The incidence of default and foreclosure for tax lien investing is very low (roughly 1%). In addition, there are fewer risks when investing in tax liens. The main ones are bankruptcy and government errors. You don’t really have to worry about market risk, and interest rate risk etc. Therefore, returns are more certain.
There’s massive opportunity – the market for tax liens is huge. It’s somewhere to the tune of US$6 billion! This means that it’s a scalable investment. If you get good at this, then there’d be no shortage of investment opportunities for you.
You can buy tax liens in a majority of states – 28 in total. In addition, you can buy tax liens in Washington D.C., Puerto Rico and the US Virgin Islands! This allows you to diversify your risk over multiple geographies (if you perceive that as a risk.)
There’s a secondary market for tax liens – if you don’t want to stay the course and collect on the tax debt, you can always look to sell on the secondary market. With so many buyers, you can get out of your position at any time. Heck, you might even be able to make money if you’re able to sell the tax lien for more than what you bought it for (for example, if interest has accumulated)!
You can start investing with small capital – tax debts come in all shapes and sizes. You could be horrendously late on a $100 tax debt. Therefore, you can start buying tax debt for as little as $100. This is only a start though. We’ll see why you might actually end up investing a lot more later in this article.
You have options if you’re unsure – With the rise in popularity of tax lien investing, so specialist investment funds have popped up. Like investing in mutual funds, you could have an experienced investment manager do the investing for you.
How do you buy a tax lien?
Tax liens are like most investment that can be bought and sold. Generally, you’ll be able to get your hands on a tax lien through an auction. These are the steps you’ll follow to invest in a tax lien:
- Decide what type of property do you want to hold a lien on – you can choose between residential, commercial and empty lots. In my opinion, this isn’t terribly important given the incidence of foreclosure is so low (i.e. you’re not going to end up with the property in most cases.)
- Decide where you want to focus your search on – choose a county that sells tax liens. You’ll want to focus on just one county at the start because the laws and procedures are different from county to county. It’s much easier for you if you become familiar with how to participate in auctions for that particular county, the laws in place etc.
- Inquire with the city/county treasurer on tax lien sales – you can get 3 important pieces of information from the county treasurer: 1) Where the next auction will be held, 2) A list of property liens that are scheduled to be auctioned, and 3) The format of the auction. You can find an example from the Denver Treasury Division here.
- Do your research on the lien – you’ll want to 1) visit the property and make sure that it’s not in terrible condition (i.e. the owner wouldn’t think of ditching it) and 2) make sure that the property doesn’t have other liens on it. You can check the property’s title with the country recorder, clerk or assessor’s office.
- Purchase the tax lien – attend the auction (can be physically or online) and bid on the liens. You should always be wary of whether you’re bidding too much for a tax lien. Generally, the rule of thumb is that your lien shouldn’t be more than 4% of the value of the property. Also, take note of the risks (we’ll go through it in the next section.)
- Post-purchase administration – If you win the auction, then you must given written notification to the property owner of your purchase. You’ll work out how the property owner will pay you back and a repayment schedule.
- Collect and manage the repayments – Now it’s time to kick back and roll in the dough. Well, that’s if your debtor is diligent in their repayments. In the event they continue to be delinquent, then you might have to undertake some firm debt collection measures. Worse, you might have to foreclose the property and evict the owners (very very unlikely though.)
Risks involved in tax lien investing
There could be other liens on the property – yes, if the taxpayer has been delinquent on other debts, then you might find that there are numerous liens on the property. This isn’t a problem IF your lien in senior to all other liens (meaning you get paid first in the event of a liquidation.) Here’s what to do if there are other liens on the property. Look out – newer liens are usually senior to older ones. So if a new lien comes along then… (see next point)
You might have to continually invest in liens on the same property – Because new liens are senior to old ones, you would want to protect your interests by also buying the new tax liens. This could see you forking out a lot more money, and putting your funds into a single property (eliminating any diversification benefits.) If you find yourself pouring too much money into the same property, I’d advice that you find a buyer on the secondary market.
The property owner might be willing to default on the tax debt – this is why I advised that you take a look at the properties before you bid on their liens. If a property is in such a bad state (rotting roof, next to chemical discharge etc.) then the property owner might be willing to default on the debt and lose the property. Trust me, this isn’t a case of woah, free property $$$. Rather, you’d have to invest so much into the repair and foreclosure process that it’s simply not worth it.
Tax liens are subject to statute of limitations – this basically means that after some time of non-payment, the debt expires and you HAVE NO RIGHT to collect on the payment anymore. This will usually be a few years though. Just be sure to be proactive in getting your money back.
You’re playing at the table with big fish – by that I mean institutional investors. These are banks, hedge funds, specialist lien investment funds etc. Hey, we’re not the only ones who’ve realized that tax lien investing is a high yield opportunity. These institutional investors have the financial resources to outbid the competition and are better equipped to do research and value the tax liens. With so much competition, you might find that yields being depressed.
Income from tax liens is is considered ordinary income – depending on which tax bracket you’re in, this could mean that your income from this tax lien investment is highly taxed. In that case, you might be better off with another investment. That’s why you might wish consider investing in tax liens using your IRA or 401k accounts.
So, should you invest in tax liens?
In this article I touched on the what, why and how’s of tax lien investing. Your question now might be, are tax liens a good investment for me?
If you’ve already built up a solid base of traditional investments (stocks, bonds, real estate etc.) then tax liens could give your portfolio that added yield that traditional asset classes can’t.
The process is more simple than you’d imagine, but as you saw from the “risks” section – tax lien investing is highly specialized and nuanced. If you master this asset class though, you could be seeing yields of 15 – 35%, which is unheard of in most investments. The fastest way to develop this specialty is to get a mentor to guide you. Then get some experience investing in a few tax liens.
Have you ever invested in tax liens? What kind of return did you see? Share them with me in the comments below!