Homeowners who fall on hard times risk losing their homes if they don't pay their property taxes. That's because local governments have the right to place a lien on the home for back taxes which prevents the property being sold or refinanced until the debt is paid. For real estate investors, this presents an opportunity. Rather than go through foreclosure, counties often prefer to auction off their tax liens. The highest bidder wins the right to collect back his investment plus an interest payment from the homeowner.
What Is a Tax Sale?
Counties and cities have a powerful enforcement mechanism when homeowners fall delinquent on their property taxes: the right to place a lien against the home. A lien is a legal claim against the property. It gives the lien holder the right to collect the tax debt, plus interest and penalties, from the property owner. The lien holder can also foreclose on the property if the debt is not paid within a certain time.
While liens give the municipality the right to foreclose, most choose to sidestep the expense associated with foreclosure and instead sell off their lien at a tax sale. Tax sales are auctions where investors bid for ownership of the tax lien certificate. Investors make money in one of two ways: by collecting interest on the tax debt from the homeowner, or by foreclosing the property and taking ownership of the title deed.
Where Do You Find Tax Delinquent Property for Sale?
Different municipalities have different rules for selling property tax liens but generally, when a lien is filed, the property will be placed on a delinquent tax list and scheduled for sale in the next auction. You can find a list of upcoming tax sales on the county website. Talk to the county tax assessor's office about how the auction works and how to participate. Some jurisdictions charge fees or deposits for participating. Most California counties, for example, charge a deposit ranging from $2,500 to $5,000 to rule out fake bidders. The deposit is refunded after the auction if you don't win.
On auction day, the winning bidder becomes legally committed to paying the back taxes and buying the tax delinquent property lien. Be sure to research the property you're bidding on so you don't get stuck with a lemon. It's easy to drive by the property and check for obvious problems like fire or flood damage. If you pay $10,000 for a tax lien and the land is only worth $5,000 because the house has burned down, you'll lose money.
You may not want to bid on a property with lots of other liens and judgments on it, like an IRS tax lien, since you'll be stuck with these debts if you foreclose. Check the title with the county recorder. You might also visit the county surveyor's office and look up their plat maps and surveys. If the property you're interested in is landlocked or has no road access, it may not be worth as much as you think.
Bear in mind that properties are removed from the auction list when the homeowner pays off the tax debt. It's a good idea to do your research as close as possible to the auction date so you're not wasting time on a redeemed property, and make sure you have an updated list.
How Does the Lien Auction Work?
There are two primary auction methods. One is known as a bid-down, where potential investors bid the lowest amount of interest they're willing to accept on the certificate. The municipality has a maximum statutory rate which can be as high as 18 percent, and investors bid down from there. Most investors come away with a rate between 3 percent and 7 percent.
The second option involves bidding a premium on the certificate. When you buy a tax lien, you are basically paying the amount of the homeowner's indebtedness – that's back taxes plus interest and penalties. The investor who pays the highest premium above this amount wins.
If I Pay Back Taxes on a Property Do I Own It?
When you buy a tax lien certificate, you're buying the right to receive a debt payment, not the deed to the house. The homeowner is still the legal owner of the home. If he does not pay the tax debt, then you can foreclose. But you cannot buy a tax lien, turn around and foreclose on the property the next day.
In every jurisdiction, homeowners are allowed a redemption period – anywhere between three months and three years – to repay the amount you paid for the certificate plus interest and penalties. It's only after the redemption period is up that you can file a foreclosure proceedings lawsuit to take ownership of the property. That rarely happens since the vast majority of tax liens are paid before the redemption date.
Here's an example. Let's say a homeowner is delinquent on their taxes in the sum of $3,000 and you've bid a 10 percent interest rate. The state also charges a $50 penalty every 6 months. You acquire the tax lien and hold it for 12 months until the owner pays off the $3,000 debt. Your earnings consist of interest at $300 (12 months at 10 percent) and $100 in penalty income (two cycles at $50). The total interest earned is $400 against a $3,000 investment. That's a win if your goal is to get your investment capital back plus a decent rate of interest. But if your goal is to buy real estate at knock-down prices, you're going to be out of luck when the homeowner pays up.
Are Tax Lien Sales the Same as Tax Deed Sales?
At the time of publication, 31 states are "tax deed states." In these states, investors bid directly on the property deed and not just the tax debt. The winning bidder will acquire legal title on auction day for the amount of their winning bid. However, homeowners still have a legal redemption period to make good on what they owe and get the title back in most states. So in reality, you're not going to get the title free and clear for several months or years. You'll lose the property if the owner redeems but you should see a return on your investment in the form of interest and penalties.
Tax deed sales are usually auctions, and the bidding starts with the amount of back taxes, penalties and interest and ratchets up from there. These auctions follow the traditional format with the deed going to the highest bidder. Other states sell tax-defaulted properties directly to buyers for a fixed price, thus bypassing the auction sale. Either way, prices tend to sit fairly close to the home's current market value. While it's certainly possible to land a bargain, it's unlikely you'll get a pennies-on-the-dollar deal.
Watch Out for Homeowner Bankruptcy
While tax liens may seem like a relatively safe investment, understand that if the delinquent taxpayer files for bankruptcy, they will be given even more time to redeem their indebtedness. Bankruptcy tends to halt collection efforts so you'll have to wait even longer to collect the return on your investment or file for foreclosure. A bankruptcy filing could also trigger a lower interest rate since the bankruptcy courts have wide latitude to reduce interest rates to help debtors get back on their feet.