Investing in a tax lien or deed for your IRA can be the million-dollar secret you need to reach your retirement goals.
In this article:
- Tax Lien Certificates: Yay or Nay?
- What Is a Tax Lien?
- Why Invest in Tax Lien Certificates?
- What Are the Important Numbers to Look At?
- What Is a Tax Deed?
Tax Lien Certificates and Deeds 101
Tax Lien Certificates: Yay or Nay?
People have different opinions about taxes. The state needs taxes to continue giving out necessary services. However, the resourceful investor can use taxes as another investment vehicle in his or her portfolio. Here are a few frequently asked questions about how tax liens and deeds function and how they can make your financial life better.
What Is a Tax Lien?
A tax lien certificate shows that an entity has a claim on a property. The entity can be the state or an individual if a person bought the tax lien. Basically, the certificate functions as a proof of mortgage. However, instead of a loan, the collectible money comes from unpaid property taxes. This basically is how tax lien investing works.
Just like a home mortgage, the state attaches the lien to the title. The individual investor buys the tax lien, which corresponds to the unpaid property taxes.
Remember those property taxes you pay each year? When a property owner fails to pay the taxes on a property, the government can auction the property to the public. Around 29 states, plus Washington D.C., have a system of tax liens.
Why Invest in Tax Lien Certificates?
Each state has their own tax rates as well as tax payment calendar. Some states will already put a lien on your property if taxes remain unpaid for just three months, while others wait for two years before doing so.
Also, with the different tax rates and legal interest rates, investors can get revenues without exerting much effort. For example, the unpaid taxes can be around $10,000 for a property worth $100,000. Each year, the state levies a tax that amounts to .005%, which gives a yearly increase of $500.
On the other hand, the investor can get interest from the tax lien. The approved state loan interest has a limit of 12% annually. Since the loaned amount is $10,000 and the interest rate is at 12%, the delinquent taxpayer pays you $1,200 as interest and then the capital payment. So, if the tax lien agreement has three years as loan lifetime, the investor gets the $10,000 back plus $3,600 as interest.
What Are the Important Numbers to Look At?
Tax lien investors watch five numbers religiously: (1) appraised value, (2) tax applicable, (3) assessed value, (4) millage rate, and (5) tax bill. The state government uses the first, three while the county uses the remaining two.
The appraised property value corresponds to the market value according to the state appraiser. The state controls the applicable tax rate, usually called property classification. Applying the tax rate applicable to the appraised value leads to the assessed value.
Simply put, multiplying the market or appraised value to the applicable tax as levied by the state gives the assessed value.
Counties used the assessed value as the base value to get the tax bill. The millage rate has a more complex structure. A mill is one-tenth of a cent ($0.001). To get the tax bill, you multiply the millage rate of the county to the assessed value.
An Example of Tax Lien Investing
For instance, the state of Alabama has a property tax approximately .325% to .43% of the property each year. You can get .43% since the residential tax rate is at 10% and the millage rate can be around 32.5 mills to 43 mills depending on the county.
For Alabama, the maximum tax lien interest rate reaches 12%. So, the investor can get annual returns of approximately 8% to 9%. Maximum redemption period is three years.
A Caveat for Tax Lien Investing
If the property owner does not pay the remaining or succeeding taxes, the state might foreclose on the property. More often than not, the holder of the tax lien has the right to pay the taxes first before the state auctions the property. However, not all states or counties have a tax lien system and auction the property off rather than offer tax liens.
If the original owner and the tax lien holder cannot pay for the taxes, the investor does not necessarily get the property as some states can foreclose and auction off the property.
What Is a Tax Deed?
Let us say that the property has a lien for taxes, but the owner never paid. The state can no longer wait, as firemen and policemen need to get paid for their services. The state then forecloses the said property and auction the deed.
Tax Deed Investing Versus Tax Lien Investing
Tax deed investing is basically buying foreclosed property at a lower price in relation to the market value. Tax lien investing is basically giving out a loan to a property owner for taxes, with the state functioning as your collector.
You can say that tax deeds relate more to property and real estate development, as you will now have land or property which you can upgrade to a rental unit or business and even flip for capital gains. A tax lien will relate more to bonds, where you loan out capital and expect a steady flow of profit and capital back.
However, the profit margins for tax deed investing can be lower since the price of the property in an auction can be higher than the cost of the tax. Most investors prefer the more stable and more straightforward tax lien investing, as money comes most of the time consistently. However, tax deed investing can give you more avenues of business development, since you can get a property to develop.
Tax Deeds and Liens in IRA
If you already have a strategy in place for tax lien or tax deed investing, then you have to prepare your portfolio. Generally speaking, only a self-directed IRAs will accept tax liens since the custodians of other IRAs don’t offer them.
If you are looking to diversify your investments, investing in tax liens or deeds can add a special twist to your portfolio. Whether you use the tax system to invest as a lender in tax liens or as a property developer in tax deeds, your IRA can have an underserved and efficient investment vehicle.
What do you think about tax liens and deeds? Between investing in liens or deeds, which is your preference? Let us talk in the comments section below.