What Is a Tax Lien Certificate? How They're Sold in Investing

What Is a Tax Lien Certificate?

A tax lien certificate is a claim against a property that's had a lien placed upon it as a result of unpaid property taxes. Tax lien certificates are generally sold to investors through an auction process.

Understanding Tax Lien Certificates

A tax lien can be placed on a property because the owner hasn't paid property taxes. The county or municipality will issue a property tax bill each time property tax comes due and it will eventually issue a tax lien if the bill isn't paid.

The lien is removed when the owner pays the taxes but the municipal or county authority will eventually auction the lien off to an investor if they continue to go unpaid. A certificate is issued to the investor detailing the outstanding taxes and penalties on the property after they've placed a winning bid. The investor will then pay the taxes on behalf of the property tax owner but now they have the lien rather than the government.

Not all states, counties, or municipalities offer tax liens. Some states such as California only hold tax sales on defaulted properties, resulting in the winning bidder becoming the legal owner of the property in question.

The term of tax lien certificates typically ranges from one to three years. The certificate enables the investor to collect the unpaid taxes plus the applicable prevailing rate of interest during this time. The rate can range from 6% up to 24% depending on the jurisdiction.

How Tax Lien Certificates Are Sold

The sale of a tax lien certificate starts when the local government sends out tax bills to property owners for the amount owed on their property taxes. The local government places a tax lien on the property if the property owner fails to pay the taxes on time. This lien is then entered in an auction that's typically held online or in person. Bidders usually have to register and provide a deposit before participating.

Investors bid on the tax lien certificates at the auction by offering to pay the unpaid taxes plus any interest and fees. The winning bidder receives a certificate that represents a lien on the property for the amount they paid. The property owner then has a period of time to redeem the lien certificate from the investor by paying the amount owed plus interest and fees. The investor is typically able to foreclose on the property and take ownership if the owner fails to redeem the certificate.

Rate of Return on Tax Lien Certificates

Tax lien certificates can offer rates of return that are substantially higher than those offered by other types of investments because they're spurred by high state-mandated rates of interest. Tax liens generally have precedence over other liens, such as mortgages.

An investor could potentially acquire the property for pennies on the dollar if the property owner fails to pay the back taxes. Acquiring a property in this manner is a rare occurrence, however, because most tax liens are redeemed well before the property goes to foreclosure.

The rate of return on tax lien certificates isn't guaranteed and can vary depending on whether the property owner redeems the certificate and whether the investor can foreclose on the property.

Benefits and Risks of Tax Lien Certificates

Buying a tax lien certificate can be an attractive investment. Some certificates have a low entry point so you can buy them for a few hundred dollars. Compare that to a traditional investment like a mutual fund that often comes with a minimum investment requirement.

You also have the option to spread your money around so that you can buy multiple certificates for a low dollar value. The rate of return is usually pretty consistent so you're not going to have to worry about the ups and downs of the market. 

Negative aspects of tax lien certificates include the requirement that the investor pay the tax lien certificate amount in full within a very short period, usually one to three days. These certificates are also highly illiquid because there's no secondary trading market for them. Those who invest in tax lien certificates must also undertake significant due diligence and research to ensure that the underlying properties have an appropriate assessed value.

Tax Implications of Tax Lien Certificates

The tax implications of tax lien certificates depend on several factors. There may be taxes imposed at the federal, state, or local levels depending on the circumstances of the certificate.

The income earned may be subject to taxes if an investor gains interest on a tax lien certificate. Interest income is typically reported on the investor's tax return in the year it's earned. The taxpayer must report the interest income as taxable income even if they didn't receive any cash distributions.

The investor will receive the amount paid for the certificate plus the interest earned if the property owner redeems the tax lien certificate by paying the unpaid taxes and any interest or fees owed. This amount is considered a return of principal and it isn't taxable income.

The investor can take possession of the property through foreclosure if the property owner is unable to redeem the tax lien certificate. The investor will then become responsible for paying taxes on the property going forward. Any income or gains earned from the sale or rental of the property will also be taxed, just as with any other property. Some states and localities may also impose taxes or fees on tax lien certificate investments.

Tax Liens vs. Mortgage Liens

A tax lien and a mortgage lien are both legal claims against a property but they're significantly different in a few ways. A tax lien is placed on a property by the government to collect unpaid property taxes. A mortgage lien is placed on a property by a lender to secure the loan used to purchase the property.

Tax liens generally have priority over mortgage liens in the event of default. The government's tax lien will typically be satisfied before any mortgage liens are paid if a property is foreclosed upon due to unpaid taxes. The individual or lender who owns a mortgage lien is more at risk of losing their principal investment and not receiving any funds.

Property owners have the right to redeem a tax lien by paying the unpaid taxes plus any interest or fees owed. Mortgage liens can typically only be satisfied by paying off the entire underlying loan. Both liens are similar in that they represent debt that may be repaid but the underlying nature of that debt is different.

Tax liens are typically placed on a property for a specific time. A local government entity may wish to sell the lien to an investor through a tax lien certificate sale after that time has passed. Mortgage liens can last for the duration of the mortgage loan which may be significantly longer.

The Bottom Line

A tax lien certificate is a representation of ownership resulting from defaulted taxes owed on a property. A local government creates a lien against the property and can auction off the rights to that lien in the form of a certificate if the taxes continue to go unpaid.

An investor who purchases the tax lien certificate may be able to recoup their principal while also earning some interest via penalty fees should the original property owner be able to pay off the tax lien in the future. But returns are often a function of risk just like other forms of investment.