Tax lien investing can be a profitable addition to your real estate investment portfolio. However, it is not without risks. Most websites, books and advertising on the subject tends to neglect discussing the risks associated with delinquent property tax liens and tax certificates. Tax lien investing works just like any other market or investment-higher returns generally correlate with higher risks. Here are five of the top risks to take into consideration before taking a step into tax liens:
1. Underlying Real Estate Risk. Just like any real estate investment, a tax lien is only as good as the underlying asset. You may have won at the Florida auction a tax certificate earning 18%. Not bad! But, wait. The tax lien is on an unbuildable parcel in the swamps of Lee county (just to pick on my favorite county). And, the owner of the property has absolutely no interest in paying taxes on this parcel because he knows it's worthless and he only inherited it from a crazy uncle. So, here you wait thinking you're earning 18% for two years but when you go to file for foreclosure (TDA), no one buys it at clerk sale and you're now stuck with this swampland responsible for insurance, taxes and its upkeep.
2. Municipal Fines, Condemnation and Demolition. This is my absolute nemesis. As an investor, you have little or no control of what your friendly code enforcement officer will decide to do to that land parcel or building you have a tax certificate on. And, don't expect the owner of the property to take care of any issues. With municipalities strapped for cash these days, it's not unheard of to have $ 500 fines each time the city comes out to cut the grass on a small parcel. To make matters worse, the federal government is giving out grants for cities to demolish whole blocks of older properties. What you thought was a nice, older property to have a tax lien on could be on the condemnation list and demolished in less than a year. And, you have very few remedies to stop it.
3. Government Errors. Who could imagine that the government could make an error? Government errors with your investment are most common in states whose county officials handle noticing taxpayers of their delinquency. But, errors can also occur by the county assessor, the courts, and even the computer systems handling taxes. If an error is found, the county will always side against the tax lien investor. They will declare your tax certificate a "sale in error" and return your investment with little interest beside a low statutory rate. While this might not seem so bad (you got your investment back, right?), Imagine your surprise when you a had a substantial, well-secured tax lien that you thought had earned two years of interest at 18% is suddenly sent back to you with only 0.5% interest because of a clerical error.
4. Legislative Changes and Court Rulings. Changes are made to tax law quite often depending on the state or municipality. All it takes is one news story about an elderly couple "thrown" out on the street by an aggressive and unscrupulous tax lien investor and the law changes that puts your tax lien in jeopardy. These not-so-friendly to the investor changes will become more and more of an issue as the foreclosure mess is dealt with by the courts and attorney generals looking to make a name for themselves (Connecticut!). Plus, we're seeing an incredible slowdown with the court system with judges taking their time in reviewing foreclosures.
5. Bankruptcy. This wasn't much of an issue until recently. Normally, if a delinquent taxpayer filed for bankruptcy protection, your tax lien would still earn interest and be a higher priority over just about every creditor. However, spurred on by the mortgage foreclosure debacle, bankruptcy courts are now taking an active role by reducing the priority of tax liens held by investors or even reducing the rate of interest on a lien.