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How to Invest in Real Estate With Property Tax Liens

Rebecca Lake

Real estate is unexplored territory for many investors who are wary of taking on the burdens of direct ownership. For those individuals, there's an alternative: tax liens.

Tax lien certificate investments are attractive for those who don't want to deal with the headaches of managing a property on their own, says Chris Varjan, senior managing director of investment sales at Lee & Associates in New York. "If you're comfortable with fixed returns and do not want any real management obligations, then this is a very compelling avenue to explore."

Tax liens investing can be less time intensive than purchasing and maintaining a property. But it may not be suited for every investor. Here are the most important things to know about using tax liens to round out a portfolio.

-- What is a tax lien?

-- The appeal of tax lien investing

-- The investor learning curve

-- Where can you find a property tax lien?

What Is a Tax Lien?

A tax lien certificate is associated with an unpaid debt. The IRS, for example, can place a tax lien against an individual or business for delinquent taxes.

In the event a homeowner is unable to pay their property taxes, their local municipality may place a lien on the property. This move is designed to create pressure for the homeowner to pay what's owed.

Within a set redemption period, typically one to three years, the homeowner has an opportunity to pay the taxes owed, along with interest. If the redemption period expires without the tax debt and interest obligation being satisfied, the lienholder, an investor, can initiate foreclosure proceedings to take ownership of the home.

In that scenario, a homeowner has one of three options, says Than Merrill, CEO of real estate education company FortuneBuilders. They can pay the past due property taxes in full, try to have to debt dismissed in bankruptcy court, along with debts owed to other creditors or reach a compromise to resolve the outstanding debt with the government agency that placed the lien.

[See: How to Invest in Real Estate Without Buying Property.]

"Either way, the government isn't guaranteed the money it's owed, which is why it's common for local municipalities to award investors with the opportunity to capitalize," Merrill says. This takes the form of a public auction, or tax sale, in which the rights to purchase tax liens are sold off to the highest bidder. The winning investor can also be assigned the rights to collect back taxes owed by delinquent homeowners as well.

Property tax liens are a way for city and county governments to make up lost revenue, says David Stryzewski, CEO of Sound Planning Group.

"Because the municipality still needs the tax revenue, they go out and sell the lien to an investor," Stryzewski says. "If the tax is not paid, the holder of the lien has the ability to legally begin a foreclosure process that places their certificate in the first position to be paid and potentially, although rarely, obtain the home."

In repaying the tax lien, the homeowner is also obligated to pay interest to the lienholder. This is what makes this type of real estate investing profitable.

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In terms of returns, tax liens can be promising. "An advantage for investing in real estate this way is that you can typically receive rates of return between 10% and 12%," Stryzewski says.

The Appeal of Tax Lien Investing

There are several reasons why tax lien investing might capture an investor's attention.

"The main advantage to investing in real estate this way is that you're sheltered from any market risk," Varjan says. "If the market declines, your returns will remain the same."

In some instances, a market turn could even be advantageous, Varjan says, for investors who are interested in foreclosing on a property. A recession, for example, could exacerbate a homeowner's financial problems, increasing the likelihood of walking away from their home altogether.

Accessibility is also near the top of the list of advantages.

"Tax lien investing requires nowhere near the same level of capital traditionally used to buy and flip a house," Merrill says. He points out that some liens can be purchased for as little as a few hundred dollars, making the initial entry point much lower compared to other real estate investments.

This type of investment strategy is less hands-on than owning a property since lienholders are not responsible for property maintenance or collecting rents. In that sense, it's similar to a real estate investment trust, known as a REIT, which owns properties and passes on the benefits of ownership to investors in the form of dividend income.

Investors can also stand a better chance of profiting because of one factor: a motivated homeowner.

"Tax liens can significantly impair any intentions the owner has to sell, refinance or borrow against the property," Merrill says. In other words, it's in their best interest to try to make up what's owed to avoid losing the home or facing other financial consequences.

The Investor Learning Curve

Before adding this type of real estate investment to a portfolio, investors should consider the potential downsides, as well as the amount of know-how that's required to get started.

"The two most obvious drawbacks to investing in tax liens are the general lack of liquidity once you've made the investment and the fact that returns are for the most part fixed," Varjan says.

It's also worth noting that profits are not always something an investor can bank on. If for any reason the homeowner is unable to pay the delinquent fees, the investor may take a loss. Not only that, but they may have to expand their investment if there are multiple liens on the property.

[See: 7 Best Real Estate Crowdfunding Platforms.]

"It's entirely possible that a delinquent homeowner has had more than one lien placed against a property," Merrill says. "While new liens take precedence over old ones, investors may be required to purchase any subsequent liens the homeowner has incurred over time before they can collect on their initial investment."

This could result in a shrinking profit margin on the investment.

Where You Can Find Properties With Tax Liens

Another reason to consider tax liens investing carefully is the amount of due diligence necessary to make a successful investment. Scouting out properties begins with contacting your city or county tax deed office to find out which properties are scheduled for auction.

"One of the biggest drawbacks of property tax lien investing is that it's difficult to keep up to date on all of the rules that each state and county has," Stryzewski says. "Additionally, these investments are very time-consuming to find and verify their quality."

For example, you'd want to check for any other liens that might be in place and assess the property's estimated value. That could make this strategy less than ideal for the beginning investor or someone with very little knowledge of real estate.

For those venturing in, here's his advice: "Investors should be familiar with the actual property upon which the lien has been placed to ensure they can collect the money from the owner," Stryzewski says. "A rundown property is probably not a good buy regardless of the promised interest rate, because the property owner may be completely unable or unwilling to pay the tax owed."

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