Self directed IRA investing in tax liens

What’s the Difference Between a Tax Lien and a Tax Deed?

Home ownership is the American dream – a dream that sometimes gets cut short by financial downturn.  Home owners can start running behind on tax payments, and when this happens real estate investors can find investment opportunities.

Both tax lien and tax deed investing involve buying properties that have delinquent taxes, but it’s important to understand how they differ.


Investing in Tax Liens

When a homeowner has fallen behind on tax payments, it starts to accrue interest and possible penalties on the delinquency, and eventually has a tax lien placed on it by the city or county in which the property is located. If it’s not paid within a certain amount of time, that governing agency can then sell the lien.

Investors typically purchase tax lien certificates at auction. The bidding for a tax lien certificate starts at the total amount owed by the property – the unpaid taxes plus accrued interest and penalties. If you are the winning bidder for a tax lien, the property owner has a certain amount of time, a redemption period that varies by state, to pay off the indebtedness.

The earnings potential in buying a tax lien certificate lies in the income you earn during the redemption period. During this period, interest and possible penalties accrue on the certificate amount. The state in which the property is located sets a maximum rate that can apply, which can run up to 18%! Once the property owner has redeemed the property, the investor collects the original investment plus the accrued interest and penalties.

If the property owner has not paid the debt within the redemption period, you can foreclose on the property, which means you will own it and can then sell it. In this way, the earnings potential also includes obtaining property at a below-market price and selling it for profit.


Investing in Tax Deeds

In this process, when a property owner is delinquent on its taxes, the governing agency takes immediate ownership of the property and then sells the deed to an investor. So, if you bid on a tax deed, you are bidding on the actual property rather than a lien.

Investors typically bid on tax deeds at auction, although some states skip the auction process and offer properties for sale directly to investors. Once you’ve won a bid, you get the deed to the property. Depending on the state, however, the previous property owner may still have a short redemption period in which they can pay off their debt and redeem the property. Similar to the tax lien process, during that redemption period you are accruing interest and penalties on the property. If the property is redeemed, you collect your initial investment plus any accrued interest and penalties. If it’s not redeemed, you, as the investor are given deed to the property.

The main earnings potential with tax deeds lies in the profit you realize when you sell the property that you may have purchased at auction for a song, or at least at a respectable amount under market value.


The Bottom Line

Whether you purchase a tax lien or tax deed depends on the state where a property is located. Most states allow either tax lien or tax deed sales but not both, although there are some hybrid states that allow both depending on the county.

Tax lien and tax deed investing can be a great way for investors to get real estate exposure, often without having to put in a ton of cash. And, in addition to the not-so-shabby return potential, self-directed IRA owners also get tax advantages when they add tax liens or tax deeds to their IRA’s portfolio.


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