What is a Tax Lien Certificate and How does the process work?
A tax lien is a lien or encumbrance placed on real property for failure to pay taxes. A tax lien is a powerful lien that, in most jurisdictions, takes precedence over mortgage liens and mechanic's liens. In essence, a tax lien becomes first priority and, if the property is foreclosed, will eliminate a mortgage lien. Generally, Internal Revenue Service (IRS) liens and local government assessments will still remain and could become the investor’s responsibility.
Here is an example of how a tax lien certificate works.
Jerry Latepay gets in some financial trouble and cannot pay his property tax bill. After a few warning letters from the county, he is delinquent. To make Jerry aware of the serious nature of property tax delinquency and start the legal ball rolling, the county places a tax lien on Jerry's property for the amount of the taxes owed. The tax lien becomes a debt on the property and must be paid off before the property can be sold or legally cleared. In most counties, Jerry Latepay is considered in default the day after his property taxes are not paid. This shows Jerry Latepay how serious the county is when it comes to not paying property taxes.
Once a year the county has a tax lien auction. If Jerry Latepay has not paid his property taxes by the time of the auction, the county includes Jerry's property in the tax lien auction. To make the tax lien enticing to investors, a state-mandated interest rate, which varies from state to state but is usually in the range of 10 to 24 percent per year, is added to the tax lien. Some states call this a penalty, while other states just refer to it as the interest rate; however, each state has its own procedures. The state then creates what is called a tax lien certificate (also called a certificate of purchase) to offer to investors at the auction. The tax lien certificate is the physical piece of paper that gives the investor a legal claim to the investment. In most states, the interest rate on the tax lien is what the bidding will start at when investors bid on the tax lien certificate created by Jerry's delinquent tax bill.
At the auction, an investor buys the tax lien certificate issued for Jerry's property. The value of the tax lien certificate is equal to the delinquent taxes owed on the property plus any penalties. When the investor buys the
tax lien certificate issued for Jerry's property, he/she is essentially paying off the delinquent property taxes owed to the county. Jerry now owes the tax lien investor all the back taxes owed plus the amount of interest due on the tax lien certificate. Although the rules vary from state to state, in most states interest starts to accrue the day the tax lien certificate is sold. Thus, the longer Jerry waits to pay off the tax lien certificate, the more money the investor earns. In some states, if Jerry waits more than a year to pay, the interest rate increases and the investor makes even more money. After a tax lien certificate is issued, there are two possible outcomes.
In about 95 percent of the cases, Jerry Latepay comes up with the money. This is because Jerry does not want to lose his home or property. Now you can see why tax lien certificates are an ultra safe investment. When Jerry comes up with the money, he pays the county, the county contacts the tax lien certificate investor, and the investor turns in the tax lien certificate issued at the auction. In exchange for redeeming the tax lien certificate, the investor receives all the money he/she invested in the tax lien certificate plus the accrued interest. This process is called redeeming the tax lien certificate. The county where the tax lien certificate was issued handles the entire process.
In less than 5 percent of the cases, Jerry cannot come up with the money to pay the delinquent taxes. In most states this means Jerry will forfeit the entire property to the investor. After following the legal process required by the state and county, the investor forecloses on Jerry's legal ownership of the property and, in return for paying all remaining liens, taxes and penalties due, the investor receives the entire property, often for a fraction of what it is worth. The period of time that Jerry has to pay back the delinquent taxes is called the redemption period, which can range from as short as six months to as long as five years depending on the state.
Talk about a win/win situation. If Jerry Latepay pays off the tax lien, the investor receives his/her original investment plus a high interest rate. If Jerry does not pay off the tax lien, the investor receives the entire property for nothing more than the property taxes due on the property when Jerry forfeits the property. Are you beginning to see why tax liens are a great, unknown investment?