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A tax sale refers to property (usually real property) being sold by a taxing authority or the court to recover delinquent taxes. Typically these are property taxes, but other entities like utilities sometimes hold the power to take property for unpaid debts.
The taxing jurisdiction can be any level of government which can assess and collect property taxes or other governmental debt, such as counties (parishes, in the case of Louisiana), cities, townships (in New England and other jurisdictions), and school districts (in places where they are independent of other governmental jurisdictions, such as in Texas).
State law offers the governmental entity a method of collecting its tax without simply having to "ding" the nonpaying person or business, by (after a specified grace period, whereby the property owner can be charged interest and/or penalties as well as other costs) placing a lien on the property which, if not paid, will result in future costs, and ultimately the property being seized and sold.
The requirements to begin the foreclosure process (and to avoid it) must be strictly followed; otherwise, the property owner will lose all rights to the property (or the governmental entity will lose its right to collect the outstanding debt). Common requirements include 1) sending a letter by certified or registered mail to any and all owners of record as shown on the entity's records, as well as to any person shown as having a lien or mortgage on the property, 2) placing a public notice in a newspaper of record, and 3) in some cases, posting notice on the property itself (such as a notice on the exterior door, or a sign if the property is unimproved).
In most places in the US, a tax lien takes priority, eclipsing other liens such as mortgages.
Once the process begins, the property owner can still avoid foreclosure, by paying the amount owed plus interest, penalties, and/or other costs or fees. The amounts can end up being quite high once the process is well under way. (NPR reported on a woman losing her home in Baltimore in May 2010 because she had missed a water payment of $360; over time her obligation multiplied to over $3,000 after penalties, interest, and other fees were added.) Even after foreclosure, in some jurisdictions the property owner can still recover the property, by paying the amounts owed within a specified time. Alternatively, the owner can file suit to have the sale set aside on grounds that the requirements were not followed (such as notice not given).
Two main methods are used by counties to capture delinquent real property tax: the tax deed auction/sale and the tax lien auction/sale.
Tax deed sale
Under the tax deed sale method, the property itself is sold.
At the sale, the minimum bid is generally the amount of back taxes owed plus interest, as well as costs associated with selling the property. In the event the property is not purchased, title may revert to the governmental entity that offered the property for sale.
Title is generally transferred in a tax deed sale through a form of limited warranty or quitclaim deed (sometimes styled as Tax Deed or Sheriff's Deed); the purchaser would most likely then need to initiate a quiet title action in order to resell the property later (as a quitclaim deed is generally insufficient to acquire title insurance). However, the property can be sold from one investor to another by cash or owner financing using a limited warranty or quitclaim deed.
Some jurisdictions allow for a post-sale "redemption period," whereby the former owner has a specified amount of time to reclaim the property by repaying the amount bid at auction plus a penalty. For example, Texas allows a 6-month (for non-homestead, non-agricultural properties) or two-year period (homestead or agricultural properties), with a flat 25% penalty to be added to the amount paid at the sale (50% after the first year), while Tennessee allows a full year, with a 10% penalty. As such, purchasers of properties at tax deed sales are cautioned not to make major improvements on the property until after the redemption period has expired, as such improvements would then become the property of the original owner.
A tax deed sale may also be used in conjunction with a tax lien sale process, whereby the lienholder (instead of a governmental agency) starts the process toward forcing a public sale of the property. In those instances the lienholder's investment (the price of the lien plus any additional costs necessary to start the tax deed sale process, such as required fees and payment of any still-unpaid taxes or buyout of other certificate holders' interests) constitutes the minimum bid; if no other bids are received at the sale then the lienholder will take title to the property subject to redemption periods (if applicable) or any lawsuit to overturn the sale.
Tax lien sale
In a tax lien sale, instead of selling the actual property, the governmental entity sells a lien on the property. The lien is generally for the amount of delinquent taxes, accrued interest, and costs associated with the sale.
Traditionally, auctions were held in person; however, Internet-based auctions (especially within large counties having numerous liens) have grown in popularity as this method allows for bidders from outside the area to participate.
In the event that more than one investor seeks the same lien, depending on state law the winner will be determined by one of five methods:
- Bid Down the Interest. Under this method, the stated rate of return offered by the government is the maximum rate of return allowed. However, investors can accept lower rates of return, including zero percent in some cases. The investor accepting the lowest rate of return is the winner. In the event, more than one investor will accept the same lower rate, a random or rotational method (see below) will be used to break ties. (Florida and Arizona use this method)
- Premium. Under this method, the investor willing to pay the highest "premium" (or excess above the lien amount) will be the winner. The premium may or may not earn interest, and may or may not be paid back to the investor upon redemption of the lien. (Colorado and Indiana use this method)
- Random Selection. Under this method, a bidder will be randomly selected from those offering a bid. Usually, a computer is used to make the selection, but in smaller jurisdictions more rudimentary methods may be used. Nevada uses Random selection since it is supposed to be the first buyer, but it is hard to determine who was the first person to the sale.
- Rotational Selection. Under this method, the first lien offered for sale will be offered to the investor holding bidder number one, who has the right of first refusal. If bidder number one refuses the lien, bidder number two may then bid. However, bidder number one will not be offered another lien until his number comes up again in the rotation. The next lien will go to the next number in line. Under this method, the investor has virtually no control over which liens s/he will obtain in the bidding, except to take or refuse what is offered.
- Bid Down the Ownership. Used in Iowa, Louisiana, and few other states, the investor willing to purchase the lien for the lowest percent of encumbrance on the property will be awarded the lien. For example, a bidder may agree to take a lien on only 95% of the property. If the lien is not redeemed, the investor would only receive 95% ownership of the property with the remaining 5% owned by the original owner. In practice, few investors will bid on liens for less than full right to the property or sale proceeds. Therefore, with multiple owners bidding on 100% encumbrance, the process then generally reverts to the random selection.
Liens not sold at auction are considered "struck" (or sold) to the entity (usually the county) conducting the auction. Some states allow "over the counter" purchases of liens not sold at auction.
The investor must wait a specified period of time, referred to as the "redemption period", during which time the lien (plus interest and any other fees) may be repaid. Usually the lien holder is not permitted during this period to contact the property owner (or anyone else having an interest in the property, such as the mortgage holder) to demand payment or threaten foreclosure, or else the certificate can be forfeit.
In some jurisdictions, the lienholder must agree to pay subsequent unpaid property taxes during the redemption period in order to protect his/her interest. If the lienholder does not pay such taxes, a subsequent lienholder would "buy out" the prior lienholder's interest.
Once the redemption period is over, the lien holder may initiate foreclosure proceedings. The proceedings (the costs of which must be paid by the lien holder, though a redeeming property owner may be required to pay them as part of redemption) may result in either acquiring title to the property (normally this will be in the form of a quitclaim deed) or a tax deed sale of the property where the lien holder has the right of first bid (and may participate by making additional bids if s/he so chooses). In Illinois a "Tax Deed" delivers a clean title as the court removes all clouds on the title in the order directing the issuance of the deed. During the period between the initiation of proceedings and actual foreclosure, the property owner still has the opportunity to repay the lien with interest plus the costs incurred to foreclose.
If the lienholder does not act within a specified period of time, as defined by state law, the lien is forfeited and the holder loses his investment. This period of time ranges anywhere from 7 to 10 years and cannot be extended unless the tax lien is officially in the process of foreclosing on the property.
A lien issued in error of state law is repaid, but usually at a far lower interest rate than had the lien been valid.
Popularity of tax lien sales
In recent years the market in tax liens has been so reliable that a number of banks and hedge funds have invested large amounts of capital in it. Bank of America, Broad Capital, RMPAM, and Fortress Investments are among the big-money participants.
The maximum rate of return on a tax lien can be far higher than other investments. For example, Florida offers a maximum rate of 18% (1.5% per month, with a guaranteed 5% return regardless of time held and regardless of the original rate bid), while Arizona offers a maximum rate of 16%. Iowa offers a guaranteed 2% per month (or 24% annual return).
Pitfalls of tax lien investing
- Some jurisdictions require a large deposit at the outset of the sale, regardless of how many certificates are to be purchased. For example, Miami-Dade County has required a $5,000 deposit, even if a buyer wants to purchase only a $150 certificate.
- Payment is usually required at purchase or within a very short time afterward (often no more than 24–72 hours). Failure to pay the full amount results in all lien certificates purchased by the investor being cancelled, and may result in the investor losing his/her deposit and/or being barred from future sales.
- In many states, further actions must be taken to protect the lien holder's rights after purchase of a lien, and generally within a certain period of time; failure to comply exactly with such requirements may make the lien worthless.
- In "bid down the interest" jurisdictions, valuable properties are usually bid to the lowest rate possible greater than zero percent. (For example, Florida permits the interest rate to be bid down to a minuscule 0.25% – though it guarantees a minimum 5% return – while Arizona allows the bid to be as low as 1%.) Similarly, in "premium" states, valuable properties are bid up above the means of an average investor.
- Unlike a certificate of deposit, tax liens are illiquid. They cannot be "cashed in" (resold to the taxing authority), but must be held until either they are repaid or the holder takes action to foreclose. (It is possible, however, to assign one's interest in a tax lien to another party.)
- Though touted as a means of obtaining property at very low cost, in practice liens are nearly always paid off prior to the auction date, and in those cases where the property is placed for auction, it is usually sold at a higher price than the price of the lien and costs to have the property sold.
- Tax lien properties sold (in non-judicial foreclosure states) are conveyed to the highest bidder via a "tax deed", which is a form of quitclaim deed. Properties sold via tax deed can be sold or transferred to third parties; however, as a quitclaim deed does not provide any guarantee of marketable title, the holder of the tax deed would then have to file a quiet title action to clear any title defects.
- Should a property be obtained via tax lien, it may still be subject to municipal liens and assessments on the property. These liens and assessments (and their related interest) can, in some instances, exceed the value of the property itself, making it virtually worthless.
- Local governments (county, city, township, town, parish) receive most of their operating funds from property taxes. When property owners default and fail to pay property taxes the local government’s method to enforce payment of those taxes is to place a tax lien on the property or seize the property and sell it for the back taxes which are due. If the property taxes remain unpaid the government in about half the states in the United States sell tax lien certificates and the others sell tax deeds at a tax defaulted auction. There are two basic systems used in the United States for local governments to recover unpaid taxes at a delinquent tax sale.