Another risk is that of a quick redemption, which can lower the yield on a tax lien. For example, if an investor buys a tax lien yielding 12% that's outstanding for only 6 months, the actual rate of return is 6%.
Perhaps the biggest risk is that the tax lien will not be redeemed and the investor will have to foreclose to recover its investment. Given historically high rates of redemption, especially on single-family residences that are owner-occupied and commercial properties with operating businesses, the risk that the investor will have to foreclose is relatively slim.
Still, it's essential to perform pre-purchase due diligence, just in case the investor winds up with the property. Liggett, who now serves as president of Distressed Real Estate Consulting Services, says his firm combs public and proprietary databases for detailed information on properties. He also gets broker price opinions and real-time photographs on some of the larger properties he's considering buying for clients.
Liggett recommends repeating the due diligence process before starting foreclosure proceedings, because of the time lag between the initial due diligence and when the investor acquires the property. "A lot can happen to a property, good and bad, in that time period," he says.
There's one more important consideration if advisors and their clients decide the potential rewards of investing in tax liens outweigh the risks-taxes. The bad news is that profits from tax lien investing are taxed as ordinary income. The good news is that IRS rules permit investing in tax liens within tax-advantaged retirement accounts.
Friedman says one solution is to set up a multi-member LLC and make one of the members a self-directed IRA. His firm provides this service to wealthy investors. "It can be done, it's just a little tricky. High-net-worth individuals know better than any of us that it's not how much you make, it's how much you keep," he says.
A Controversial Investment
According to NTLA Executive Director Brad Westover, most local governments fund about 35% to 85% of their budgets through real estate taxes. When property owners don't pay their taxes, city and county governments have only three choices: reduce services, increase taxes on those who do pay or borrow to cover budgetary shortfalls.
While auctioning off tax liens may cause hardship for property owners who must pay interest on their tax debt, the counter-argument is that local governments need cash flow to provide basic services, such as policing, fire protection and public education.
Nevertheless, the perception that investors are taking advantage of hapless property owners is one reason that most investors establish limited liability companies, trusts or other entities to bid on tax liens. Family offices and affluent investors in particular may not want to be publicly identified with an industry that critics say benefits from the economic misfortune of others.
The U.S. Department of Justice has recently prosecuted several high-profile cases of illegal bid rigging at tax lien auctions. Some cases still under investigation allegedly involve tax lien servicers, hedge funds and banks.