Tax Liens

Upon beginning its decline in 2000, trillions of dollars were pulled out of the stock market as investors began to pursue options that were not exposed to the equity markets. The real estate market was a large beneficiary of the money flowing out of the stock market. Another investment category that is gaining traction and benefiting from increased awareness is tax liens.

Every single year, those that are fortunate enough to own real estate are required to pay property taxes. Those taxes vary depending on the value of the land and the structure that occupy the land. If a homeowner holds raw land, the tax bill is going to be less than if it had a home or structure built upon the property. The property tax revenue collected is how the counties pay their bills. Those monies are allocated to fund county services and programs, such as police and fire departments, as well as schools and libraries.

The county typically will assess taxes every six months – once in April, and once in October. Generally, home and land owners, as well as investors, pay their property taxes in one of two ways – directly or indirectly. "Directly" is when the county sends you a bill. Assume you have a $3,000 property tax bill due annually on a rental property. Since taxes are due twice a year, the county would bill you for half the total amount every six months. With a $3,000 tax bill, you would receive a $1500 bill every six months - which, in turn, would require you to write a check for the amount due. These sorts of tax payments are made when a home/land owner owns the property in cash or they have a mortgage where the taxes are not billed by the mortgage company and escrowed (an impound account). "Indirectly" paying property taxes usually involves an impound account (extremely common).  In this case, you make a payment to the mortgage company that includes your principle, interest, taxes and insurance (referred to as PITI in the industry). The taxes are held in an escrow account and are then sent directly to your county, by the mortgage company. The banks in most cases want to roll that tax payment into the payment you owe them. So there’s an easy way for them to monitor whether or not you’re paying the taxes on the property. They have a vested interest in making sure the tax payments are made on time and for the right amount. We’ll explain this later.

If the taxes are not paid, then the county would be unable to collect the revenue required in order pay its bills and operate the services and programs it’s responsible for. In other words,the county has to collect that money. So how do counties and local governments ensure they can collect the tax revenue and not fall short, or as short, on funding. Here is how it works: Let’s say you have a $3,000 tax bill that’s due. As the property owner you’re a little short on cash and, because you don’t have an impound account on the mortgage, the taxes were not automatically paid on your behalf. Because of the lack of liquid business capital (you didn’t plan for this well), you are unable to make the tax payment. The county will, in turn, assess a penalty or interest charge (possibly both), to provide incentive for you to pay that bill. Otherwise, nobody would pay their property taxes. The penalties vary from state to state.

So let’s say that what you owe is $3,000, and the penalty is a flat 10% annually. You’ve got an extra $300 that you have to come up with. If you are unable to make the property tax payment on time, the government will place a lien on your property so they can make payroll for the defaulted tax amount and then sell that tax lien. A lien is a claim against an item by another “party” that utilizes that item as security for repayment of a loan or other claim. A lien affects the ability to transfer ownership. You may be familiar with a mortgage, which is also a type of lien. Banks and lenders require borrowers to sign a deed of trust or mortgage against the property so that they have some sort of secured ownership of that property. You cannot sell or transfer ownership on the property until that lien is satisfied or paid off.

Functionally, the way that a lien works is this: if a lien has been placed on a property, for say $10,000, then when somebody goes to sell that property for $100,000, the escrow company that handles where the funds go is going to pay off that lien before ownership can be transferred to the new party. Then, the net proceeds go back to the person who’s selling the property.

For example: A homeowner did not have an impound account nor did he adequately prepare for the tax bill that has just arrived. He is simply unable to pay the taxes, and so the county will turn around and place a lien on the property for the amount due…plus the penalty (which, for this example, we’ll assume is 10%). The county, however, cannot sit on a laundry list of accounts receivable, so they sell the lien at a discount (only for the amount of the defaulted tax bill) to an investor. If the tax bill, still using previous numbers, is $3000 and the penalty is a flat 10%, the county will have placed a lien on the property for $3300 ($3000 in taxes, $300 in penalties). They will sell that lien to an investor for $3000, leaving the reward of that 10% penalty to the investor when the taxes are satisfied.

The nice thing about tax liens is they, with few exceptions, take first position on the property. So even if a mortgage has a $200,000 lien on the property, they just got bumped to second position -- because taxes always take priority…that is the beauty of being the government! It is for this reason that banks oftentimes will require you to carry a mortgage with an impound account. If they can ensure the tax payments are made, then they are likely not going to find themselves in an exposed position.

Let’s get back to our example. Let’s say that the homeowner was able to scrape together the $3,300 dollars that is now due on the lien. He can go down to the county or use the mail to make that tax payment. Once the lien amount is satisfied, the county will release the lien and send the money to the investor allowing them to recapture their investment plus the proper interest due.

The interesting part of this is that it is actually a win-win-win situation for everybody. The homeowner has now been able to extend the period for which the taxes are due (albeit it is at a price), which is clearly a win for them since they lacked the necessary capital at the time.

A good example of this…

Let's assume a homeowner has lived in their house for 50 years. Let's also assume that, much like the rest of the country, their value has skyrocketed.  If they originally purchased their home for $30,000 and it now has a value of $300,000, their annual taxes owed will have increased from around $500 to nearly $5,500 each year - something that most people living on Social Security would struggle with.  Sadly, we see the elderly failing to keep up with rising property taxes all too often.  As a result, there has been legislation passed in some areas (e.g. Bay of California) where property tax laws have been adjusted for the elderly.

Typically, a county gives anywhere from six months to two years to pay back owed taxes and the penalty. So you’ve got a little bit of time. That’s helpful. The second win is for the county. They get the money needed for operational cash flow so that the services they provide do not suffer. Because the county charges an interest rate but does not collect it, they pass it on to the investor – and, thus, the third win is given to the investor when the interest or penalty is realized as profit. Tax liens can create a win-win-win for everybody.