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Bennie Smith Jr. was looking for a way to build his wealth quickly when he bid on two property tax liens in Decatur, Illinois.
He bought one on a vacant home in his former neighborhood for about $5,000 and another on a vacant lot for $600. His plan was to take over the properties if their owners did not pay the lien within a designated amount of time. He wound up getting ownership of the first one, and earned about $100 on the vacant lot a couple of weeks after the sale, when the owner paid to redeem it.
A tax lien is placed on a property by a municipality or city when the owner fails to pay real estate taxes, as well as water and sewage bills, in a timely manner.
More than $14 billion in property taxes goes unpaid across the United States and, of the 30 states and District of Columbia that sell tax liens, $4.2 billion of that is sold to private investors, according to the National Tax Lien Association, a nonprofit that represents tax lien investors, governments and servicers.
The benefit for governments is that they get the money owed immediately, while the buyer reaps the benefits of interest and penalty fees if the homeowners redeem the property. If they do not, buyers of the lien can foreclose.
While TV infomercials and real estate guru books have lauded returns and the opportunity to score a property for next to nothing, neither is likely, said Brad Westover, executive director of the NTLA. Yet, for the savvy investor aware of the many risks, tax liens can be a great way to diversify a portfolio.
"As long as you are smart and invest safely, you will be fine," he said.
On the other hand, Derek Tharp, a financial advisor for Conscious Capital Private Wealth Management in Cedar Rapids, Iowa, said he wouldn't recommend tax liens for most investors. "That's not to say that I wouldn't advise a client on the use of tax liens if they had the necessary knowledge, time and resources, but I just haven't found that to be the case for most people," he said.
Here what you need to know if you want to dabble in tax liens:
While a municipality's established interest rates and penalties could top 20 percent annually, the rates in some districts are actually often bid down in each sale to as low as 6 percent to 9 percent, Westover says. In other cases, the winning bid maybe awarded to the person who bids for the lowest percentage of ownership in the event of an eventual forced sale, or to the person who bids the highest on the lien, over and above the amount owed.
In addition, a bank holding a mortgage is likely to step in and pay off the lien, especially for a very valuable property, rather than lose the home. Given that, the best investments often are on properties owned free and clear.
Alex Feick, managing director of Denver-based Paragon Capital Management, said he once put together a fund to invest in tax liens but soon discovered that the market was too small and the yields unattractive because people were bidding over the amount owed on the property, which brought down the rate of return.
"Much of this irrational behavior was predicated on the belief that bidders could eventually end up with the property … an event that is quite rare," Feick said.
Only about 6 percent of delinquent tax liens wind up in foreclosure, and of those, only one half of 1 percent are successful in that they are not redeemed [before the foreclosure is complete], according to the NTLA's Westover.
If you do wind up foreclosing on a property, consider the costs of repairs and unknown problems. Smith set aside $10,000 for his property's rehab, but he contacted the family of the previous owners to gather information on its condition. (The family was willing to let it go in the sale.)
Tharp at Conscious Capital Private Wealth Management says some municipalities charge bidders certificate and redemption fees, along with fees required to serve the owners notice of the sale. Westover of the NTLA advises bidders to divide the face amount of the delinquent tax lien by the market value of the property. It should be no more than 4 percent.
"I no longer invest in tax liens for several reasons," said Tharp. "The primary reason is an ethical concern.
"These aren't real investments that generate benefit for society the way that most companies and entrepreneurs do," he added, citing lien sales generally as the result of people having fallen on hard times.
If a tax lien on an occupied property needs to be foreclosed, you have to be willing to kick the occupants out, possibly even seeking the professional help of a property manager or attorney, which could cost thousands of dollars (though that's generally refunded to the lien holder if the owner redeems the property before the foreclosure is complete).
Tax lien investments are not for novice investors and can be far from lucrative, financial advisors agree.
There's a "huge amount of due diligence that needs to be done on the front end in order to ensure big mistakes are not made," Tharp said, because sometimes the value of the parcel may actually be worth less than the tax liability, or the property could have other liens against it that the purchaser must pay to clear title.
If tax lien investing interests you, consider a more passive investment with a professional who does it all day, every day. It's not a hobby. More than 80 percent of tax liens purchased in the U.S. are by NTLA members, which include tax lien investing fund managers.
"A fund will [generally] yield higher because you won't have the same losses or write-offs" that improve net gains, said the NTLA's Westover.
— By Kayleigh Kulp, special to CNBC.com