Investing in tax liens fraught with risk
By Dan Weil • Bankrate.com
- Investors buy tax liens for the right to collect taxes and interest from a property owner.
- If the property owner doesn't pay up, the lienholder can foreclose on the property.
- Interest rates on tax liens range from 5 percent to 36 percent, depending on the state.
Tax liens, an obscure corner of the real estate market, can offer bountiful returns to sophisticated investors. But those who haven't done extensive research can easily get burned, so this isn't a pursuit for novices.
Here's how it works: When a property owner fails to pay his or her taxes, the municipality in which the property is located can sell its tax lien -- the right to foreclose on a property when the owner has failed to pay taxes.
Investors buy the liens in an auction, paying the amount of taxes owed in return for the right to collect back that money plus an interest payment from the property owner. The interest rate ranges from 5 percent to 36 percent, depending on the state, according to TaxSales.com. The property owner has a redemption period -- generally six months to three years -- to pay the taxes plus interest.
If the property owner fails to pony up the property taxes by the end of the redemption period, the lienholder can initiate foreclosure proceedings to take ownership of the property. But that rarely happens: The taxes are generally paid before the redemption date.
The interest rates make tax liens an attractive investment. Liens also are first in line for repayment, even before first mortgages. "I've had a few clients and friends who have invested in tax liens on a big-time basis almost as a business and have done well," says Martin Cass, managing director of Alpern Rosenthal accounting firm in West Palm Beach, Fla. "But it's complicated. You have to understand the details."
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The auctions can be held on the Internet or in person and work in several different ways, depending on the municipality.
One is known as bidding down the interest rate. The municipality establishes a maximum rate, and the bidder asking for the lowest interest rate beneath that maximum wins the auction.
Another variation involves bidding a premium on the lien. The bidder who offers to pay the highest premium above the lien amount wins the auction. The premium can earn interest and may be paid back to the lienholder at redemption, but not always.
Individual investors who are considering investments in tax liens should keep one point in mind above all: Do your homework. "You have to know the property," says Richard Zimmerman, a partner at Berdon LLP accounting firm in New York City.
"You should really understand what you're buying.
Be aware of what the property is, the neighborhood and values, so you don't buy a lien that you won't be able to collect." You want to avoid properties with environmental damage, such as one where a gas station dumped hazardous material.
You also have to be careful about when you do your research, says Joanne Musa, a tax lien investment consultant in East Stroudsburg, Pa. "People get a list of properties and do their due diligence weeks before a sale," she says. "Half the properties on the list may be gone because the taxes get paid. You're wasting your time. The closer to the date you do your due diligence, the better. You need to get an updated list."
Besides checking out the property and all liens against it, the prospective bidder also should check the prices for sales of similar properties and the prices for sales of recent tax liens.
Things to learn
If you win a lien at auction, you must learn your responsibilities. For example, in Illinois, within four months of purchasing a lien, you're required to notify the property owners that you possess the lien and can foreclose if they don't repay, Musa says. Then another letter must be sent before the end of the redemption period.
Tax liens also have an expiration date. "Sometimes it's six months after the redemption period," she says. "Don't think you can just buy and forget about it."
At that point, the property owner has probably already lost the right to the property. But any rights held by the lienholder expire when the lien has expired.
After you've bought a lien, you may want to pay taxes on the property in the years that follow, so no one else can purchase a lien and thus have a claim on the property. That would mean you'd have to place another lien on the property.
Richard Rampell, chief executive of Rampell & Rampell accounting firm in Palm Beach, Fla. was part of a small group that invested in local tax liens in the late 1990s and early 2000s. At first, the partners did well. But then big institutional investors, including banks, hedge funds and pension funds, got involved in auctions around the country, tempted by the high yields.
The bigger investors helped bid down interest rates, so Rampell's group wasn't making significant money anymore on liens. "At the end, we weren't doing much better than a CD," he says. "For the amount of work, it wasn't worth it."
Given the entrance of big investors into the tax lien market, it's more difficult for individuals to acquire attractive liens.
You also may encounter difficulty gaining title to a property in the event of foreclosure. For example, it may have other liens, Rampell says. "This is something the average investor shouldn't look at," he says.Source: www.bankrate.com