Aja McClanahan is a personal finance writer who has a story of getting out of over $120,000 in debt. She's been featured in Yahoo! Finance, MarketWatch, U.S. News and World Report, Kiplinger and has written for publications like Business Insider, Credit Karma, Inc., and many others. Aja writes about investing and personal finance for Wealthsimple. In her spare time, she manages her own investment portfolios for herself, husband, and two kids. Aja double majored in Spanish and Economics and holds a Bachelor of Arts degree from University of Illinois at Urbana-Champaign.
Investing in real estate has always been touted as a great way to build your net worth while adding some diversity to your portfolio of assets. However, what you might not know is that there are several ways to invest in real estate. From buying and holding properties for rental to flipping and acquiring holdings in real estate investment trusts (or REITs), there are plenty of ways to get involved in real estate investing.
One route to real estate riches could include tax lien investing. With this method, you can earn money by collecting interest and even acquire real estate at huge discounts in the process. If you’ve ever wanted to learn more about investing in tax liens, this break down will help.
What is tax lien investing?
Tax lien investing is the process of purchasing tax lien certificates. When a homeowner doesn’t pay their property taxes, the county places a lien against that property for the tax debt owed. A lien prevents a property from being sold or refinanced unless the taxes are paid.
The reason purchasing tax liens is referred to as investing is because the lien holder can earn a return via collecting interest on their initial tax lien purchase. Because of the potential returns, tax lien investing can be attractive to both individual and institutional investors.
Tax lien investing isn’t for the casual investor, however. The rules and regulations vary from state to state and get even more nuanced at the county level. In order to earn a reasonable rate of return on tax lien certificates, you’ll have to educate yourself on exactly how they work for the region(s) you’ll be investing in.
How tax lien investing works
Tax liens are tax debts that can be purchased and sold for investment purposes. Because the county still needs this property tax revenue, it allows investors to pay the homeowner’s tax bill. In exchange for purchasing the tax lien certificate, the investor is allowed to collect interest on the outstanding debt once the homeowner redeems the taxes on their property.
In many cases, these tax liens are sold at an auction. At these auctions, the interest rate is bid down. Investors are basically deciding what is the lowest interest rate they’ll accept for a particular tax lien certificate before they purchase it.
How can investors earn a return with tax liens?
In many states, property owners have a grace period where they can redeem the property taxes that have been sold to an investor. Upon paying the delinquent property taxes to county, they will also have to pay interest to the owner of the tax lien certificate.
Depending on the state or county, homeowners will have a set amount of time, say 2-3 years to redeem their taxes. So the return you can earn over this amount of time could be worth the initial investment of buying the property tax debt.
In terms of the potential returns, the interest rates you can earn will depend on the jurisdiction where the tax lien certificate is purchased. Each state has an interest rate ceiling on tax lien certificates, but it is not common to acquire tax liens at much less than the maximum rate allowed by state statutes. As mentioned before, many states and counties have “bid down” auctions so the interest rate you could receive as an investor could be substantially less than the allowed maximum.
In terms of rates, you could earn anywhere from a 2% to 18% return based on state laws. According to the National Tax Lien Association, interest rates for these liens average between 3%-7%. ( t tIt’s also worth noting that a tax lien interest rate is simple interest and not compound interest.)
If a property owner doesn’t redeem their property taxes within the allowed redemption period, the owner of the tax lien certificate can foreclose on the property and take ownership of it. For just a few thousand dollars, someone could become the owner of home, a great deal when compared to the traditional home buying route.
The risks of tax lien investing
Though there’s plenty of potential to earn money via tax lien investing, it can be fraught with risks and downside. In order to get the best returns on tax liens investments, you’ll have to do thorough research on how to purchase, maintain, and dispose of this particular asset.
Rules and regulations
Tax lien investing is governed by a myriad of rules and regulations that vary by location. Not only do states impose laws about how tax lien collections work but there are often laws at the county level regulating tax liens.
Unless you take the time to research and follow these rules, you could risk losing money. It can take years to develop an efficient process for identifying and acquiring certificates that are worth your time and money.
Administrative duties and costs
Tax lien investing has become incredibly competitive, and it’s not a set-it-and-forget it asset. It’s a high-touch activity that requires research to find the best deals and understand your responsibilities and limitations as a lienholder.
For example, you have to keep track of dates, deadlines, paperwork filings, etc. In terms of costs, unless you are managing all the administrative tasks yourself, you may need to hire someone to perform duties that help in the upkeep of your tax lien portfolio.
If you decide to purchase a tax lien certificate, of course, you’ll need the initial capital to take ownership of the debt. Then you’ll also be responsible for paying the property taxes until the homeowner redeems them. Otherwise, another investor could purchase the delinquent taxes from under you.
Foreclosure is rare and still has risks
Novice tax lien investors may purchase these certificates with hopes of owning a home for very little money. This may happen, but more than likely, you’ll only get the interest payments when the homeowner redeems their taxes.
If the homeowner doesn’t redeem the taxes, you’ll eventually get the right to foreclose on the property in order to take ownership of it. Foreclosure is time-consuming and costly. It’s also a long process that can take many months or even years.
You’ll need cash reserves to hire legal counsel for the proceeding and cover any associated filing fees. Plus, after all this time has passed, the value of the property could have dropped substantially, which could negate your investment returns.
In the event that you do take ownership of the property, you might find that there are major defects to the property that make it nearly worthless. Large projects like roofing, plumbing, electrical, or foundation work could make for a property that’s hard to sell or refinance.
Also, if the property has not been cared for, it could be encumbered with municipal fines, citations, and judgments you could be responsible for depending on when you take ownership of it. Another issue could be obtaining a clear title to the property, which could take more time and money to clear up if there are issues.
Finally, if a property owner declares bankruptcy, your ability to foreclose on the home due to delinquent property taxes may be delayed or lost altogether. This is a risk that you may not foresee and that could cancel out your investment returns.
Alternative methods of investing
If the risks and administrative hassle of investing in property tax liens doesn’t seem worth it to you, there are other ways to earn a solid 3%, 5% or even more on your hard-earned money.
For one, you could invest in tax lien certificates with the help of a servicer or buy into a fund that invests in tax liens. This method is more passive and could yield less returns than a more hands-on approach but it’s still a way to invest in this asset class without being materially involved in the day-to-day aspects of managing a tax lien investment operation.
If you’re not particularly committed to investing in tax lien certificates, there plenty of other asset classes that can offer decent returns including:
Certificates of deposit (CDs)
With investing, there are almost no get-rich-quick formulas. You’ll either have to put in the time or the money for a solid return. Whether you choose to invest in tax lien certificates or any other asset, the returns will take time to be realized. At the end of the day, you’ll want to invest in things you understand with prospects for long-term growth.
If, alas, you still aren’t sure where to get started with investing, you might be a candidate for an automated investment strategy. With this approach, your main responsibility is keeping up with contributions. You supply the funds and they are invested on your behalf based on your personal financial goals. If you’re a busy person overwhelmed with the idea of investing but still want to get started, automated investing services could be perfect for you.
If you’re ready to start investing on auto-pilot, Sign up with Wealthsimple. It’s the only automated investing services to offer all of its clients unlimited human support. Every Wealthsimple client gets state-of-the-art technology, low fees, and the kind of personalized, friendly service you might have not thought imaginable from a low-priced investment service.