What Are Tax Liens?

We often are asked about tax liens, specifically investing in tax liens with a Self-Directed IRA.  While many Self-Directed IRA trustees do not provide the checkbook control typically necessary for success in tax lien investing, theCureIt Financial IRA/LLC absolutely does provide the checkbook control needed.

Here is how a tax lien works: a county has property owners who are behind on their property taxes.  The county needs that tax revenue to pay its bills and cannot wait for the property owner to get their finances in order or until the law permits the county to foreclose on the property in order to collect.  So the county puts the debt up for auction, seeking investors who will pay the county the money that they need now, in exchange for a promise of their money back plus interest.  In most cases the interest promised will be double digits in the form of a penalty that the property owner must pay to get caught up or that gets tacked on to their debt owed at foreclosure.  In some counties the penalty is 20% or even 25%.

No matter how many tax liens you bid on you will never get 25% interest on your money.  Here is why:  Investors bid on the debt by stating how much of the maximum penalty they are willing to accept.  So an opening bid might be 24% followed by 22% and bid on down from there until someone has a final bid that promises them a return somewhere south of 25%.  Banks and other professional investors will come to auctions with large budgets measured in the tens or even hundreds of thousands of dollars and just bid as low as it takes to win. 

In fact, many investors assume that no matter what the starting bid may be that the winning bid will be for a return in the single digits or even nothing at all!  For example in FL, where the average winning bid is under 3%, bidders are willing to go that low because there is a mandatory 5% premium added to any winning bid.  So that 2% bid you won will actually pay out at 7%.  Another reason a winning bid may go low is that once you own the lien you own first rights - at full premium - for any subsequent tax liens that property may garner.  Would you be willing to accept single digit returns on most of your investments if a handful of those investments led you to 15%-25% returns a year later?  In some states, notably New Jersey, property taxes are due quarterly and so buying the first lien may lead to a second full premium (18% in NJ) tax lien available to you without competition just 3 months later.  In New Jersey it is not unheard of for investors to not only agree to receive zero premium but actually to pay an extra premium to the county just to get their hands on those potential no-bid 18% future tax liens.

Consider too that very few tax lien go unpaid all the way to foreclosure auction.  In fact,according to the National Tax Lien Association 99% of tax liens are redeemed by the property owner prior to foreclosure proceedings, so the odds are strongly with the investor that the return on investment will come sooner rather than later. If the lien you buy for a 5% premium is redeemed in 6 months that is actually an annualized return of 10%.

In order to protect the investors who are helping the county meet their budgets, and to encourage many bidders, the tax liens are foreclosable after a period of 2, 3 or 4 years depending on the state.  In addition tax liens are paid out at sales before the banks’ mortgage liens or any other liens with the exceptions of only State and Federal tax liens.  Because the tax lien is ahead of most other liens it is nearly certain that debt will be repaid even if the property must go to auction.  For further protection, if the property is not sold at auction, all liens - including the bank liens for mortgages - are void and the title to the property is transferred to the investor who covered the property tax bill at auction. 

We want to acknowledge that the percentage of tax lien investments that result in the property’s title being transferred to the tax lien investor free and clear for just the cost of a few years tax bills is very low, single digits or fractions of a digit, recall the National Tax Lien Association’s claim that 99% of tax liens are redeemed by the property owner.  Nonetheless it does occur, we have working with clients who have had that very experience. Perhaps equally rare are the cases where the tax lien investor is left with no return at all.  In fact we have never worked with a client who had that experience but it is important to understand that it is possible to lose money with a tax lien investment.

Since repayment of your investment in the tax lien is guaranteed by foreclosure the only way you can lose money is if you invest in the tax lien of a property that has zero value or perhaps even negative value.  How might a property have zero or negative value?  The first thought is that the property is burdened with mortgages in excess of the properties values, yet that is not a concern with a tax lien investment.  The tax lien holder will always be paid before the banks are paid so the amount of mortgage to value is not a concern for the tax lien investor.  However federal and state income taxes do supersede the position of the county tax lien.  It is possible that the property owner owes more in state and federal income taxes than the property is worth.  It is also possible that the property is so damaged that the clean-up of the property would cost more than it is worth. 

Only 28 states offer tax liens so one challenge that you may encounter if you consider tax lien investing is that they’re not available where are.  Some states have passed laws to bring tax lien auctions online and so the location based limitations are starting to disappear.  Florida in particular has been leading the way in bringing tax lien auctions online.  When using a Self-Directed IRA/LLC for Checkbook control of your IRA investments, you can bid in any state that you wish, however be aware that some states may require you to file an extra form known as a Foreign Entity Application before you can complete your investment.

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Leigh Young

Leigh Young

Realtor - Veteran Specialist
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