The Pitfalls of Tax Lien Investing

By investing in a tax lien, you may win the deed to what has become a worthless asset. The rocky real estate market means that property values swing down as easily as up, and your parcel may attract little or no interest among buyers or at a public foreclosure auction. If you can't sell it, you still own it, meaning you are the one now responsible for the costs of maintenance, taxes, and insurance premiums.

In many locales, the foreclosure crisis has put both commercial and personal property markets into a state of general chaos. Stepping into this scene as a tax lien investor means you're at the center of the storm if you foreclose on your property. The foreclosure could be tied up in the courts if the previous owners are trying to delay or quash the sheriff's sale and repossession. The states are passing new foreclosure laws generally intended to keep people in their homes, even if they're in default on mortgages or taxes, and this trend runs directly counter to your interests. As speculators in distressed property, tax-lien investors often don't get much consideration by the courts or the law -- and their claims are subordinate to any federal tax liens that may also have been placed on the property.

If you hold a tax lien -- whether it's on a house, office building, or vacant lot -- you may be held responsible for any code violations found on the property, as well as assessments for improvements such as road work, new sewer or water lines, sidewalks, curbs, street lights, gutters, and so on. If the owner of the property decides not to pay -- remember, he's already not paying the taxes -- the authorities may look to you as the next party responsible. In addition, neglected property can be subject to condemnation and demolition, which means a court fight if you want to save the building and a destruction of assets if you don't. In practice, most tax liens on property of value are redeemed before you can foreclose.

If the previous owner declares bankruptcy, you still have the right to foreclose on a property where you hold a tax lien. Normally, the lien would still generate interest and your lien remains a priority claim according to the bankruptcy laws. Seeking to keep individual debtors in their primary residence, however, a bankruptcy court may deny your claim, knock it down to a non-priority claim, declare the property exempt from seizure, or discharge your tax lien altogether, in which case you won't be repaid.

While bank deposits, stocks, bonds, and other investments can be redeemed, withdrawn, or sold fairly easily, a tax lien is not a liquid investment. The investor cannot return the tax lien to the taxing authority for a refund, nor is there a public market for tax liens. Instead, the tax lien remains in your portfolio until it is either redeemed by the property owner or you foreclose. You do have the right to assign the tax lien rights to another party, if you can find one.