Another creative method of purchasing real estate is through tax deed auctions. This method can be very profitable if executed properly.
As I discussed in a previous post, The Real Estate Market Post Coronavirus, major changes are coming to the real estate market. Under the Cares Act, there is a temporary moratorium on foreclosures and evictions, as well as provisions for mortgage forbearance. As long as these policies remain in effect, the market should remain fairly stable.
The damage to the economy has yet to be fully appreciated but it has been generally acknowledged that the damage has been severe. There is now a possibility of a second lockdown which will just add to the damage, specifically, more business closures and higher unemployment.
Many municipalities have seen their tax revenues severely impacted and are likely to raise taxes. Property taxes will be one of the main targets. Many homeowners, especially those that have been thrown into unemployment will be unable to pay those higher property taxes.
What happens when you cannot pay your property taxes?
If you are unable to pay your property taxes, the local government has two options;
1) They will foreclose on your property to collect the taxes owed.
2) They will sell a tax certificate to a private investor, in essence, transferring the debt to the private sector.
At the time of this writing, 30 states have procedures in place that allow for the sale of tax certificates. For more information on tax certificate sales, go here.
Tax Liens vs. Tax Deeds
Before we proceed, we need to clarify the difference between a tax lien and a tax deed.
A tax lien is essentially a lien against the property for unpaid property taxes. This lien is what is sold at tax lien auctions. The tax liens are sold to investors prior to a tax deed being sold.
A tax lien auction is very different from a regular auction. Depending on the municipality, tax liens might be bundled in amounts of $25,000 or higher. Investors will then bid on the interest rate they are prepared to accept. The bidding will start at a high rate of interest, perhaps as high as 25%. The bidding will continue downwards and will stop when there are no investors willing to bid any lower.
In this market of low interest rates, investors may bid as low as 5%. If you are the lucky winner of the auction, you are entitled to collect the interest on the taxes owed for that property or group of properties.
In some states, the municipality is responsible to collect the tax and interest payments. If unable to collect, the municipality will sell a tax deed to collect the amounts owed. In this situation, the risk is very low so investors will accept a lower rate of interest.
In other states, it is up to the investor to collect and, if unable to collect, to initiate foreclosure proceedings to recoup his investment.
A tax deed is the sale of title to the property. It is important to note that tax liens take priority over every other kind of lien, including construction liens, and yes, even mortgages. Upon completion of the sale of the tax deed, all other liens against the property are eliminated. If you are the successful bidder, you are effectively buying the property for the past due property taxes. It sounds like a great deal but it is not that simple.
In order for a tax deed to be legitimate, all lien holders as well as the owner need to be notified of the pending tax deed auction. They have 90 days to respond. The only exception is the IRS which has 120 days to respond. Notifications are sent to the last known address of the interested party.
In the event that a lienholder was not properly notified, he can challenge the tax deed in court. In that event, it is the responsibility of the municipality to satisfy the claim and make the investor whole.
Before you even consider bidding on a tax deed, you have to do your homework. There are 3 categories that need to be investigated.
Chain of Title
An attorney or title company needs to conduct a title search to determine what liens are on the property.
If there are liens on the property by the municipality such as unpaid water bills, they will not always show up on the title search. You should contact the municipality to verify that no municipal liens are outstanding on the property. Municipal liens survive the sale of the tax deed, so if you are the winning bidder, you will be responsible to satisfy those liens.
Most importantly, you need to know what you are buying. The municipality will only give you the address of the property and the amount of property taxes that are owed. It is up to you to determine the underlying value of the property.
The first way to determine the value is to physically inspect the property yourself. If the property is occupied, you have no right to enter the premises. You can only inspect from the street.
The second way is to hire an appraiser and request a written report. The appraisal will tell you what comparable properties sold for, or are currently listed on the market. The appraiser is also not entitled to enter the premises, so the condition of the property is an estimate at best. It is prudent to assume the worst.
You have completed your due diligence and you are armed with the necessary information to make a bid.
Larger municipalities will conduct tax deed auctions online while smaller ones will have live auctions conducted at the local courthouse. Every municipality has a different procedure. In some municipalities, you submit your highest and best offer, and the highest offer wins.
In many municipalities, the competition for tax deeds is fierce. You need to be prepared to bid well above the amount of property taxes owed. For example, let’s assume that a property owner owes $20,000 in past due property taxes, and there are municipal liens in the amount of $5,000. However, even in its worst condition, the property still has a market value of $250,000. If you could get the property for $100,000, it would be a bargain. Some investors might be prepared to bid even more.
After the Auction
Congratulations! You won the auction and the property is now yours. However, it is not over yet. There are a number of steps you need to take before the property Is marketable.
Even though all other liens have been removed, they may still be listed on the title. The tax deed nullifies any interest that a lienholder may have against the property but it is your responsibility to have them removed. Why is this important?
Until the liens are all removed, the title will be considered to be “clouded” by any title insurance company and they will be unwilling to provide title insurance. In essence, that makes the property unsaleable.
Quiet Title Action
The traditional method of clearing title is through a process of quiet title action. This is a court proceeding whereby all lienholders are officially notified that they no longer have a legal interest in the property. Any lienholder can challenge that assertion.
This process requires an attorney and the process can take months, sometimes longer. Therefore it is important to include the legal costs into your overall cost base.
There is nothing to stop you from renovating or demolishing buildings on the property. Once your renovations are complete, you are free to rent out the premises to prospective tenants. Your only impediment will be obtaining financing and selling the property.
Tax Title Service
The second method is to engage the services of a tax title service company. They will investigate all liens, identify any risks, and will then issue a certification. Many will also obtain title insurance for you once this process is complete.
The Bottom Line
Purchasing real estate at a tax deed auction can be a lucrative investment but it is not for the inexperienced investor. Secondly, purchasing a tax deed requires substantial cash reserves. They cannot be financed. When you win the auction, the payment must be made within 3 business days. Some municipalities may require proof of funds in order to qualify for bidding.
As the real estate market begins to unravel as a result of the economic damage from the coronavirus lockdown, more homeowners will be unable to pay their property taxes and many more properties will be sold at tax deed auctions.
It is important to note, that if the mortgage is held by one of the big banks, they will receive notification of a pending tax deed auction. Most likely, the bank will pay the past due property taxes in order to protect their mortgage interest in the property.
Despite this, the opportunity to purchase tax deeds at auction will increase and those investors that have the means could profit handsomely.
The information provided here is for educational purposes only and is not to be construed as professional legal, tax or financial advice. Every situation is unique and you should consult with an attorney, tax accountant, or financial adviser to determine the best options for your personal situation.