There are always potential risks when you invest in tax liens and deeds. Below we will carefully explain how to avoid them. Tax lien investing is exceptionally safe. The government made it that way, but there are some risks. We want to make you aware of these risks and how to avoid making a mistake easily.
What Is a Default?
Default is the failure to repay a debt, including interest or principal, on a loan or security. A default can occur when a borrower cannot make timely payments, misses payments, or avoids or stops making payments. Individuals, businesses, and even countries can default if they cannot keep up their debt obligations. Default risks are often calculated well in advance by creditors.
Default Explained
A default can occur on secured debt, such as a mortgage loan secured by a house or a business loan secured by a company's assets. If you fail to make timely mortgage payments, the loan could go into default. Similarly, if a business issues bonds—essentially borrowing from investors—and it's unable to make coupon payments to its bondholders, the business is in default on its bonds.
Defaults can also occur on unsecured debt, such as credit card debt. A default has adverse effects on the borrower's credit and ability to borrow in the future.
Defaulting on Secured Debt vs. Unsecured Debt
When an individual, a business, or a nation defaults on a debt obligation, the lender or investor has some recourse to reclaim the funds due to them. However, this recourse varies based on whether the debt is secured or unsecured.
Secured debt
If a borrower defaults on a mortgage, the bank can reclaim the home that secures the mortgage. Also, if a borrower defaults on an auto loan, the lender can repossess the automobile. These are examples of secured loans. With a secured loan, the lender has a legal claim on the asset to satisfy the loan.
Corporations in default or close to default usually file for bankruptcy protection to avoid an all-out default on their debt obligations. However, if a business goes into bankruptcy, it effectively defaults on all of its loans and bonds since the original amounts of the debt are seldom paid back in full. Creditors with loans secured by the company's assets, such as buildings, inventory, or vehicles, may reclaim those assets in place of repayment. If there are any funds left over, the company's bondholders receive a stake in them, and shareholders are next in line. During corporate bankruptcies, sometimes a settlement can be reached.
With that said, here are a few more pitfalls to look out for:
- Liquidity
- Emotional Bidding
- Low-Value Properties
- Environmental Issues
Liquidity
Liquidity: The ability to sell an asset and convert it to cash.
This is only risky if the investor's cash invests in a tax lien or deed is tied up for an extended period of time. An investor's money is tied in a tax lien until one of two things happens:
- Property owners redeem liens by paying the county the delinquent taxes, penalties, and fees in full.
- Redemption period passes, and the certificate holder forecloses and sells the property.
A tax deed investor's money is tied up until they execute their exit strategy. The investor might want a cash flow property. Each month the investor receives a check from the renter, or the investor may want to sell it, then exit when the property sells. For some investors, this is important to consider, but it is not a risk. If you need money in the near future for things such as buying food or gas, you should not invest that money unless you know you will cash out quickly.
If an investor needs to exit a tax lien certificate, they can sell it to another investor. We have seen them listed on eBay.
The main thing to look at for a tax lien, tax deed, and redemption deed investors is the redemption period. Consider the most prolonged time period your money will be out of pocket. If you are fine with it, go for it.
Emotional Bidding
Emotional bidding can be described as a state of mind in an auction setting where a bidder gets emotionally caught up to the point where they bid away their returns.
Example: A tax deed investor that is interested in a $50,000 property sets a maximum bid limit of $25,000. Another bidder in the room is competing with the investor and continues to bid higher. The bidding reaches beyond $25,000 and the investor bids until the return is gone.
There are two ways to lose money in tax deed investing: Bid away return through emotional bidding (or bidding too high due to a lack of due diligence) or buying a property with little or no real value. Researching before attending the auction and sticking to your limits will help you to avoid making both of those mistakes. To avoid bidding away your return:
- Research beforehand
- Make sure property values are solid
- Set maximum bid limit after considering your exit strategy and after you know the maximum amount you can spend to make a sufficient return
- Stay cool at the auction
Low-Value Properties
This is quite simple to avoid but is the risk you need to keep in mind more often than the others.
What are low-value properties? Useless land such as a lot in the middle of the desert, far from access to civilization, might be considered low value. We only consider it low value because your options after purchase are limited. Beware of land with easements on it since they can prevent the investor from making changes to the property.
A good indication of useless land is the assessed value. If the land has an assessed value of $1,000, move on to another investment. Even if the land has a high assessed value, check the location of the land. A piece of land with an assessed value of $500,000 might be in the middle of the Texas desert when no one can reach it.
Other properties you may want to avoid are:
Flood or swampland: May come up in Florida or other southern states.
Landlocked properties: Surrounded by other land and lack public access. To access your land, you have to get permission.
You can avoid both of these property types by looking at a mapping service in the assessor's office or Google Maps.
To avoid making a purchase on a property with low to no real value:
- Check the assessed value and look at the property using a mapping service.
- Do not buy a property based only on the legal or property description.
- Do some due diligence, so you know exactly what the property is.
Environmental Issues
This is uncommon, but something you need to be aware of. U.S. Code Title 42 Section 9601 states property owners are responsible for contamination even if it existed prior to ownership. This is not a problem for tax lien holders since the investor is not the property owner unless he or she forecloses on the property but should be considered a tax deed investor.
This is easy to avoid since all you have to do is look at county records and in most cases, these issues are undeniable. If you are buying an old gas station that experienced underground erosion, you probably have environmental issues. A safe way to avoid environmental problems is sticking to residential land and homes. Residential homes and improved lots usually lack environmental issues.
Other Risks
You may want to consider bankruptcy and federal liens. They will not wipe out a tax lien certificate but can postpone repayment. In some cases, the foreclosure will not wipe out a federal lien. If you are buying a tax lien or deed on a property you want to own, avoid federal liens.
One way to check for any risks we have discussed is through the county records. If you do not find what you need, you can do a title search. You will do a title search if you have questions about a particular property you want to buy. A title search can cost from $25 to $150, depending on the required detail.
There are links on this website's resources page to some online title search companies if it comes to that. If you have any questions about potential risks, please give us a call, and we would be happy to help.
Marketplace Pro Software
You will have to complete the amount of due diligence before bidding on tax lien certificates, or deeds will vary from deal to deal. You can get an idea of how much due diligence may be needed when you evaluate the property description, and this is when Marketplace Pro software comes in handy.
Suppose you are familiar with the Multiple Listing Service platform used by real estate brokerages. In that case, you will love the intuitive user interface of Marketplace Pro, which is the first step tax lien investors should take when evaluating investment opportunities.
Contact our office today to arrange a free demo of Marketplace Pro; once you get the hang of it, we can start discussing due diligence strategies.
