How A Tax Lien Investment Can Go Wrong

Previously, we learned how tax liens allow investors to pick up default taxes, and receive repayment or the ability to foreclose on property to recoup their investment. 

Since a tax lien certificate entitles the holder to recieve repaid taxes or foreclose on a piece of tax-default property, it seems like the investor always walks away with something in their pocket.   So, how can this not be a slam dunk?

Well, even an investor in the stock market still owns something when their stock tanks, it just might be worth as much as they paid for it.   The risks are much higher investing in stocks, but there is still the possibility of ending up with less money than you started with after the tax lien has been satisfied.

  • First, tax liens aren’t free.   There are fees involved in recording the documentation.   In my previous example, if an investor buys a tax lien on Monday and the lien is paid on Tuesday, the investor is still out the money spent on filing fees.  It might not be much, but it can still leave an investor in the red.
  • A tax lien might not pay anything for years, which is why the county passes the expense on to an investor.  The best investment in a tax lien is when the back-taxes get paid off, but just not too soon, so that interest can build.   If there are $1,000 in back taxes at 10% interest, that’s $100 a year…but only after the taxes and interest are paid by the tax defaulter.  On paper, things will grow, but the return isn’t realized until the taxes are paid.  Sitting on a large sum of money out, waiting for interest to be paid, is not always a sound investment when there are more steady returns in bonds or mutual funds.
  • Who doesn’t pay their back-taxes on a nice house?  The properties that end up in tax default are properties that the owner feels are of no value to them.   Then, the properties are often vacant or otherwise ignored while the foreclosure clock keeps ticking.
  • There is a pecking order for repayment after a foreclosure. A tax lien is often the first, but not always; bankruptcy, back federal taxes, judgements, and other problematic things might mean that the tax lien holder doesn’t just get to own the property outright, and these are the sort of problems that cause back taxes to go unpaid anyway.

So, in summary, making money off owning a tax lien certificate is a Goldilocks condition.   You want the taxes to get paid off not too soon, and not too late; you want the property to be lien-free but also valuable enough to recoup investment; you want the price paid for the lien to be low enough that the chance of making more than your cost and fees is optimal.

Coming soon – Part 4: How Do I Improve My Tax Lien Chances?