What Is a Tax Lien Certificate?
A tax lien certificate represents a legal claim against a property with unpaid property taxes. These certificates are often sold to investors through an auction process, enabling local governments to recover owed taxes.
Key Takeaways
- Tax lien certificates document a claim against a property with unpaid taxes.
- Local governments place liens on properties with overdue taxes and may auction these liens to investors.
- Investors buying tax lien certificates hold a legal claim on the property equal to the lien amount.
- Investors can potentially earn money through interest and penalty fees if taxes are eventually paid.
Understanding Tax Lien Certificates
Municipalities issue a tax lien when property taxes remain unpaid past the due date. When these taxes aren’t cleared, the local government usually auctions the lien to investors. The winner then pays the owed taxes on the owner’s behalf, receiving a certificate that outlines the taxes and penalties. Some states only sell tax liens, while others, like California, sell defaulted properties directly, transferring ownership to the highest bidder.
The certificates typically have terms ranging from one to three years and enable investors to collect unpaid taxes plus interest, often between 6% and 24%, depending on the jurisdiction. Auctions for tax lien certificates can be based on the highest bid amount or the lowest interest rate.
How Tax Lien Certificates Are Sold
When property owners fail to pay their due taxes, the local government issues a tax lien on the property. This lien is then auctioned, either online or in-person, to interested investors. Bidders must typically register and provide a deposit before participating.
Investors bid on the tax lien certificates by offering to cover unpaid taxes plus associated interest and fees. The highest bidder receives a certificate for the amount paid, representing the lien on the property. The property owner then has a specific period to redeem the lien by repaying the investor with added interest and fees. Failing redemption, investors may foreclose on the property and take ownership.
Rate of Return on Tax Lien Certificates
Tax lien certificates can offer higher returns, thanks to state-mandated high interest rates. These liens hold priority over other claims like mortgages, increasing their secure nature. While acquiring property through foreclosure on a lien is rare, it shows the potential exponential gains for investors.
Still, it’s essential to bear in mind that the rate of return varies and isn’t guaranteed. Several factors, like the property owner’s ability to redeem the lien, influence these returns. Moreover, tax lien certificates encourage taking note of local property tax deadlines to anticipate potential investments.
Associated Benefits and Risks of Tax Lien Certificates
Tax lien certificates can be attractive, often available at entry-level costs of a few hundred dollars. Compared to traditional investments with minimum requirements, these certificates allow diversification for low dollar amounts. However, they come with challenges: quick payment requirements, illiquidity, and necessity for thorough property-value due diligence.
An illustrative example: a 2-acre lot may seem like a bargain, but it could be a narrowly unusable strip of land - an essential research takeaway.
Tax Implications of Tax Lien Certificates
Earnings from tax lien certificates can be subject to federal, state, or local taxes. Interest earned must be reported as taxable income, regardless of actual cash receipt. When property owners redeem the lien, investors recuperate their principal and the interest earned (non-taxable). If foreclosure occurs, investors must handle ongoing property taxes and income taxes on rental or sale earnings. Some localities may also impose additional fees or taxes.
Tax Liens vs. Mortgage Liens
Both tax liens and mortgage liens are claims against properties, but differ in several respects. A tax lien covers unpaid property taxes and takes precedence over mortgage liens, offering substantial investor security. In foreclosure cases involving both, tax liens are satisfied before mortgage liens.
Property owners may clear tax liens by repaying overdue taxes plus penalties, while mortgage liens are settled by repaying the loan. Timespans for tax liens are usually specified and may involve compulsory sale, whereas mortgage liens often persist for the entire loan term.
Is Tax Lien Investing a Good Idea?
Tax lien investing may attract diversifying investors seeking exposure to real estate without direct ownership obligations. However, comprehend the mechanisms, regional property markets, and conduct meticulous pre-investment research.
What Are the Risks of Tax Lien Investing?
Risks include overbidding, misunderstanding redemption periods, and potential bankruptcy filings by defaulting taxpayers. Assess each factor to mitigate these risks.
Does a Tax Lien Hurt Your Credit?
Tax liens do not directly impact credit scores but may be public records. This exposure hints that a person holds outstanding tax liabilities.
The Bottom Line
Tax lien certificates provide ownership claims over defaulted property taxes. Local governments auction these liens, enabling recouping of owed amounts. Investors earning interest payments on redeemed liens profit from municipal defaults, recouping outstanding taxes with potential interest. Discretion and in-depth knowledge about local real estate investment rules enforce safer and wiser investments.
Related Terms: property taxes, auction, interest rate, foreclosure, principal, investment, mortgage lien.
References
- The National Tax Lien Association. “Common Questions about Tax Liens”.
- State of California. “Public Auctions and Bidder Information”.
- Tax Lien University. “Tax Lien States That Sell Tax Lien Certificates”.
- Real Estate Center. “Priority of Mortgage and Tax Liens”. The Law Letter, vol. 10, no. 2, Winter 1996 (Revised Oct. 2005), pp. 1.
- Internal Revenue Service. “Topic No. 403, Interest Received”.
- Internal Revenue Service. “Publication 550, Investment Income and Expenses (Including Capital Gains and Losses)”. Page 20.
- Rocket Mortgage. “Tax Lien Investing”.
- Experian. “Tax Liens Are No Longer a Part of Credit Reports”.
