How Do I Use a Self-Directed IRA to Purchase a Tax Lien?

Local governments generally sell tax liens to the highest bidder.

Local governments generally sell tax liens to the highest bidder.

Each year, local government authorities in 26 states, Washington D.C., Puerto Rico and the U.S. Virgin Islands sell about $6 billion in tax liens to investors, according to a Dec. 20, 2012, article in Forbes magazine. A tax lien is a financial instrument that gives investors the right to collect taxes from delinquent property owners and charge them interest and penalty payments. County and municipal governments use them to recover the tax dollars property owners fail to pay. The profits from tax liens are taxed as ordinary income -- not at the lower rate reserved for capital gains. This has encouraged some investors to minimize their tax liability by buying tax liens through their self-directed IRAs.

Open a Self-Directed Checkbook IRA

Self-directed IRAs allow you to save for your retirement by investing in a wide variety of financial instruments while benefiting from important tax savings. IRA investments include the usual suspects: stocks, bonds and mutual funds. Additional options are real estate and tax liens. IRA assets typically are managed by a trustee or a custodian. However, because tax liens are usually sold at auctions, investors require direct control over their assets. This means you'll need an especially flexible relationship with an agile IRA custodian or you'll need to create a self-directed limited liability company that gives you checkbook control of your IRA assets. A self-directed IRA LLC is a custodial company that grants you direct access to your IRA savings so you can purchase investments, such as a tax lien, by simply writing a check.

Do Your Homework

Tax liens are complex investments that require an understanding of the property law of your state, how to buy at an auction and the ability to navigate the sea of paperwork involved. Also, if the property owners don't pay their taxes, you may have to foreclose on the property to recover your investment, a highly specialized procedure. Consider hiring a mentor or investing in a training program before you start investing.

The Tax Lien Process

When property owners are delinquent on their property taxes, local government authorities responsible for collecting taxes may auction out the right to collect the taxes plus interest and penalties. Although the government doesn't back or protect your investment, a tax lien does give you the right to take over the title of the property, which is generally much more valuable than the cost of the tax lien. Because tax liens are issued by the government, they take precedence over private liens, such as mortgage creditors, trust deeds and judgment liens, which means you get paid before any other creditors.

The Auction Process

Depending on local rules, tax liens are auctioned out to either the highest bidder or the buyer willing to offer the lowest interest rate. If the highest bidder system is used, the interest rate charged to property owners is fixed and the the investor willing to pay the most for the lien wins. However, in auctions based on the lowest interest rate, the price of the lien remains the same. The bidder who is willing to accept the lowest interest rate wins.

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