One specialized way to earn income off real estate without owning any is to buy a tax lien. Someone else's misfortune or bad planning could bring you a healthy return on investment.

But there's a reason that tax lien investing stays niche. It carries a high risk and is complicated. If you value your time and energy highly, the work required to succeed at tax lien investing might not be worth it.

Here we boil down tax lien investing to the basics and explain the pros and cons of this viable but complicated money-making option.

What Is Tax Lien Investing?

When an owner fails to pay property taxes, the city or county can attach a lien to the property. The lien serves as a public record that taxes are owed. The property cannot be sold or refinanced until the debt is paid, which removes the lien. If the debt is never paid, the lienholder can foreclose on the property (if the mortgage holder hasn't already foreclosed on it).

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To generate revenue sooner rather than later, some local governments auction off these tax liens in the form of certificates. Not all states permit the sale of delinquent tax liens, but 28 states do.

When you buy a tax lien certificate, you're required to pay the taxes, interest, and penalties all at once. The debt is now yours to collect. As the holder of the tax lien certificate, you are entitled to collect the delinquent balance plus interest from the property's owner.

You might make 10% to 18% in interest with tax lien investing. That's a substantial return, but convincing owners to pay up probably won't be easy, much can go sideways, and tax liens eventually expire.

Therefore, individual investors have much to consider when they wade into the tax lien investing pool. One of the first steps recommended would be to consult a financial advisor who belongs to the National Tax Lien Association, a national nonprofit trade association.

Step by Step: How Tax Lien Investing Works

An investor would buy someone else's tax debt with a plan to recoup the money plus interest over a short period. The rate of return can be high, but so can the risks. After all, the investor needs repayment from the property owner, who is the same person who didn't pay the government.

Let's walk through the process of tax lien investing, from the property owner's first delinquent tax bill to the investor's (hopeful) profit. We've boiled it down to four steps.

1. Local government places a tax lien on the property.

When a property owner fails to pay taxes, often despite repeat notices, a local government might place a tax lien on the property. This is a public record that taxes are owed. Until the lien is lifted, the property can't be sold or refinanced.

2. An auction is held to sell the tax lien certificate.

In the 28 states that permit the selling of tax liens to private parties, the most common way is by auction. Auctions can be held anytime of year and will be announced by the city or county treasurer's office in advance. Some are held in person, others online.

3. Investors bid on the certificates.

You win a tax lien auction either by bidding the highest price for the certificate or the lowest interest rate that you're willing to charge the owner, depending on the rules of the auction. Either way, to win, you will probably have to give up potential profit. Bidding wars can quickly slash potential profits.

The winner of the tax lien certificate pays the full tax tab in cash, which makes the local government happy.

4. The lienholder tries to collect the debt.

The winner of the tax lien certificate now notifies the property owner to establish a repayment plan. The schedule usually lasts anywhere from six months to three years. A shorter plan will recoup your money faster; a longer plan will bring you more money in interest.

Time is of the essence. When the repayment term expires (it varies by state), the lienholder can no longer collect the taxes owed.

A Tax Lien Certificate Rarely Gets You the Property in the End

Tax certificates do not transfer title or ownership of the property to the investor. Although they are one stepping stone on a long path that could lead to transfer of title to the investor, only 2% of tax liens reach that conclusion. The other 98% of properties with tax liens are redeemed by the owner before foreclosure, according to NTLA.

Even if you should become the new owner via foreclosure, you might face expensive hassles, such as critical repairs or evicting the current tenants.

“In the United States, an estimated $21 billion of real estate property taxes become delinquent annually.”

—NTLA

The Risks and Responsibilities of Tax Lien Investing

Almost as many complications can arise with tax lien investing as there are types of real estate out there: undeveloped land, residential buildings, commercial buildings, or land with improvements. Any of those property types could have a tax lien up for auction.

Let's look at the primary risks of tax lien investing.

Tax lien investing requires a lot of research.

Novice investors with little real estate experience should steer clear of tax lien investing because it requires effort and knowledge. For starters, you should examine every potential property closely, and you need to know what you're looking for.

For example, it would be disastrous to purchase a tax lien for a site with environmental damage, such as a lot where an auto mechanic’s shop dumped hazardous material. The owner of such a blighted site might be glad when foreclosure makes someone else responsible for the expensive cleanup.

Research the property owner as well. You might find a reason he wouldn't or couldn't pay the taxes owed. Or the owner could be impossible to find in the first place.

You face stiff competition from banks.

Banks and hedge funds are increasing their tax lien investing to the point where an individual investor can have trouble competing for certificates. These firms have dedicated research departments and can find and analyze properties before a regular Joe hears about them. And they have deep pockets to outbid everyone else at auction because their profits come from quantity.

Tax liens often carry expiration dates.

The owner of a tax lien certificate usually has a limited window of time to collect the debt, perhaps three years. If the property goes into foreclosure, other liens may be discovered on it, so getting the title could be impossible. You might be left holding a certificate you can no longer collect money on for a property you can never seize.

Tax Lien Investing
✅ Pros ❌ Cons
Low capital investment No recurring income
Return on investment Very slow process
Variety of properties High effort
Can start w/ fund High competition

The Upside of Tax Lien Investing

Given the risks and complexity of tax lien investing, you might wonder why anyone would choose this avenue over other ways to make money. Well, with big risk can come big rewards. Here are a few notable advantages that might come with tax lien investing.

You could charge a high interest rate.

The biggest advantage of tax lien investing is the high interest rate you might be able to charge the property owner, up to the percentage allowed by the state. In Florida you can really stick it to the owner and charge a whopping 18%. Arizona caps the rate at 16%, and in Alabama the rate is fixed at 12%. These figures come directly from the NTLA.

Remember that to win the tax lien certificate at auction, you may have had to bid down your interest rate. You won't be able to charge the property owner more than that.

Rising property taxes mean more tax liens for sale.

Across the country, municipalities are assessing more and more property taxes as values climb. While rising home values usually make homeowners happy, in many states they also bring a higher tax bill. California is a notable exception; your property tax is assessed the first year and doesn't change.

As property taxes and other living expenses rise faster than wages, more tax bills will go unpaid, generating more certificates that tax lien investors can buy.

Conclusion

Tax lien investing has a good rate of return unless you value your time and energy highly. This is anything but a passive investment. This is not some stock you buy and watch go up and down on screen from the comfort of your chair.

With tax liens, you must research the property and owner beforehand, win the lien at auction, collect the debt before the lien expires, and deal with any hassles that emerge if you aren't paid back (like if the property has other liens or needs expensive repairs).

The best way for an individual investor who isn't a real estate expert to get into tax lien investing is to look into funds that invest in tax liens, a recent option. If you go this route, a professional will research the properties and manage the liens, and you buy a share in their performance. This lowers your potential return, of course, but also your effort and risk.

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