Common Misunderstandings About Investing in Tax Liens
Even the most novice investor is familiar with a basic real estate transaction. After all, over 60% of Americans own their homes; so buying real estate is, for the most part, an understandable process.
Real estate investing can get a lot more complex, however, and certain investments require more knowledge than others to navigate. Tax lien investing is one example; it holds a lot of potential, but there are also a number of misconceptions regarding how it works.
Above Average Returns
If you’re considering investing in tax liens, you may have heard stories about their amazing returns. While these are often exaggerations, there is some truth to the rumors.
When you purchase a tax lien, you’re buying a property’s tax debt in the form of a certificate issued by the county or municipality in which the property is located. The property owner has a certain amount of time to pay off the debt – a redemption period that varies by state. During that period, interest accrues on the certificate amount and that interest rate, which is set by the state, can run up to 18%! When the property owner eventually pays the debt, you collect your initial investment plus the accrued interest.
Here’s the catch. You typically purchase a tax lien certificate at auction. Oftentimes, you’re bidding on a tax lien along with any number of other investors. Those investors are either bidding up the price or “bidding down” the interest rate, which will reduce the payout when the homeowner redeems. So while you might profit well if you win a bid, there’s a chance your awesome returns could become pretty average or non-existent.
What happens if a property owner doesn’t pay the debt within the redemption period? As the tax lien certificate holder, you now have the right to foreclose. Ideally, you’ve just acquired ownership to a property that you bought for the cost of its tax debt. You can now turn around and sell the property for a nice profit.
While this result is not out of the question, it’s a best-case scenario. Remember, the cost of your investment comes out of the selling price of the property. If you bid too high, there goes your profit. It’s important to adequately research a property before you buy a tax lien certificate. The property may require costly repairs or may even be worthless. Furthermore, most homeowners – over 90% – do redeem their properties within the given time frame.
Easy to Invest
Tax lien investing is often considered an easy investment. You don’t need to have a ton of cash to invest; tax lien certificates may be purchased for just a few hundred dollars. And anyone can bid on a tax lien; you don’t need a real estate license to do so, you just have to register.
However, just because you can invest in tax liens doesn’t mean you should. The actual auction process can be complicated and time-consuming. It often requires searching through numerous properties and narrowing them down to a promising few, which is then followed by a losing bid. Successful investors are the ones who understand the process and know how much of a bid is too much.
You must also be aware of your responsibilities as a tax lien holder. You may be required to send certain notices to the property owner. In the event you foreclose on a property, you need to initiate the process within a certain amount of time. Failure to follow the rules could be costly; in some cases your entire investment may be lost.
Tax lien investing has been around a long time, however, and for good reason. For savvy investors who are willing to put in the time and due diligence, purchasing tax liens can generate healthy returns. And for self-directed IRA owners, those returns can grow tax-deferred or tax-free.