What Is a Tax Lien Certificate?

A tax lien certificate is a certificate of claim against a property that has a lien placed upon it as a result of unpaid property taxes. Tax lien certificates are generally sold to investors through an auction process.

Understanding Tax Lien Certificates

A tax lien certificate is a lien placed on your property for not paying your taxes. Every time your property taxes come due, the municipality will issue a property tax bill. If the bill is unpaid, then they will issue a tax lien. Once you pay your taxes by the due date, the lien is removed. If you don't pay your taxes—or don't pay them on time—the town or county will auction off the tax lien certificate to an investor(s). That investor will then pay the taxes on behalf of the property tax owner.

After an investor places a winning bid for a specific tax lien certificate, a lien is placed on the property, and a certificate is issued to the investor detailing the outstanding taxes and penalties on the property. Not all states, counties or municipalities offer tax liens. Some states, such as California, only perform tax sales on a defaulted property, resulting in the winning bidder becoming the legal owner of the property in question.

The term of tax lien certificates typically ranges from one to three years. The certificate enables the investor to collect unpaid taxes plus the applicable prevailing rate of interest, which can range from 6% up to 24%, depending on the jurisdiction.

How Tax Lien Certificates Are Sold

The sale of a tax lien certificate starts when the local government sends out tax bills to property owners for the amount owed on their property taxes. If the property owner fails to pay the taxes on time, the local government places a tax lien on the property. This lien is then placed in an auction and is typically held online or in-person. Bidders usually have to register and provide a deposit before participating. At the auction, investors bid on the tax lien certificates by offering to pay the unpaid taxes plus any interest and fees. The winning bidder receives a certificate that represents a lien on the property for the amount they paid. The property owner then has a set period of time to redeem the tax lien certificate by paying the investor the amount owed plus interest and fees. If the owner fails to redeem the certificate, the investor may be able to foreclose on the property and take ownership.

For a property to be eligible, it must be considered tax-defaulted for a minimum period depending on local regulation. Instead of bidding on an amount for the property, the interested parties bid on the interest rate they are willing to receive. The investor who bids the lowest rate wins the auction and is issued the tax lien certificate.

Rate of Return on Tax Lien Certificates

Spurred by the high state-mandated rates of interest, tax lien certificates may offer rates of return that are substantially higher than those offered by other investments. Tax liens generally have precedence over other liens, such as mortgages. If the property owner fails to pay the back taxes, the investor could potentially acquire the property for pennies on the dollar. Acquiring a property in that manner is a rare occurrence since most tax liens are redeemed well before the property goes to foreclosure.

In some states, the interest rate is fixed by law. It's also important to note that the rate of return on tax lien certificates is not guaranteed and can vary depending on whether the property owner redeems the certificate, whether the investor is able to foreclose on the property, and other factors. Like other forms of investment, investment returns are often a function of risk.

Associated Benefits and Risks of Tax Lien Certificates

Buying a tax lien certificate can, at times, prove to be an attractive investment. Some of the certificates have a low entry point, meaning you can buy some of them for a few hundred dollars. Compare that to a traditional investment like a mutual fund, which often comes with a minimum investment requirement. You also have the option to spread your money around so that you can buy multiple certificates for a low dollar value. And finally, the rate of return (as we mentioned above) is usually pretty consistent, so you're not going to have to worry about the ups and downs of the market. 

Negative aspects of tax lien certificates include the requirement for the investor to pay for the tax lien certificate in full within a very short period, usually one to three days. These certificates are also highly illiquid since there is no secondary trading market for them. Investors in tax lien certificates also have to undertake significant due diligence and research to ensure that the underlying properties have an appropriate assessed value.

An example regarding the need for due diligence when researching tax lien certificates is a two-acre lot that may initially seem to be a good value, but it's actually a strip of land that is only 3 feet wide by 5 miles long. This renders the land unusable for many endeavors, such as building a home or a business.

Tax Implications of Tax Lien Certificates

The tax implications of tax lien certificates depend on several factors. There may be taxed imposed at the Federal, state, or local levels depending on the circumstances of the certificate.

If an investor earns interest on a tax lien certificate, that income may be subject to taxes. The interest income is typically reported on the investor's tax return in the year it is earned; even if the investor did not receive any cash distributions, the taxpayer must report the interest income as taxable income. If the property owner redeems the tax lien certificate by paying the unpaid taxes and any interest or fees owed, the investor will receive the amount paid for the certificate plus the interest earned. This amount is considered a return of principal and is not taxable income.

If the property owner is unable to redeem the tax lien certificate, the investor can take possession of the property through foreclosure. The investor will become responsible for paying property taxes on the property going forward. Any income or gains earned from the sale or rental of the property will also be taxed, just like any other property. Some states and localities may also impose taxes or fees on tax lien certificate investments.

Tax Liens vs. Mortgage Liens

A tax lien and a mortgage lien are both legal claims against a property. However, they are significantly different in a few ways. A tax lien is placed on a property by the government to collect unpaid property taxes, while a mortgage lien is placed on a property by a lender to secure a loan used to purchase the property.

Potentially most important to investors, tax liens generally have priority over mortgage liens in the event of default. This means that if a property is foreclosed on due to unpaid taxes, the government's tax lien will typically be satisfied before any mortgage liens are paid. This also means the individual that owns a mortgage lien is more at-risk to lose their principal investment and not receive any funds.

Property owners have the right to redeem a tax lien by paying the unpaid taxes plus any interest or fees owed. Mortgage liens can be satisfied by paying off the underlying loan. In this manner, both liens are similar in that they represent debt that may be repaid. The underlying nature of that debt is different. Last, tax liens are typically placed on a property for a specific period of time. After that time has passed, a local entity may wish to sell the lien to an investor through a tax lien certificate sale. Mortgage liens can last for the duration of the mortgage loan which may be significantly longer.

The Bottom Line

A tax lien certificate is representation of ownership regarding defaulted taxes owed on a property. When a local government is unable to collect property taxes, it creates a lien against the property and may auction the rights to that lien. Should the original property owner be able to pay the tax lien in the future, the investor who purchased the tax lien certificate may be able to recoup their principal while also earning some interest via penalty fees.