Wednesday, May 02, 2007

Tax Lien Investing: Know What You’re Bidding!

I attended a tax lien sale in New Jersey yesterday. This particular sale is in the township that I used to live in, and I know it well, so I attend this sale every year. Last year I was able to pick up a couple of small sewer liens there for 18%. This year I came away with nothing. Almost everything went at premium, even small sewer liens.

Investors were bidding hundreds of dollars in premium on small sewer liens with no open taxes. They are sure to make very little profit if anything at all on this type of lien when they pay that much premium. So why do they do it? Some of the investors there I knew were bidding for large funds or tax lien investing companies, they paid quite a bit of premium for tax liens that had amounts due of over $1000.00. The largest lien in the sale was for $22,000.00 and went for $205,000.00 to one of these institutional buyers.

But this I understood, I know that these companies figure out just how much they can pay on these larger liens and still make a profit. Once they have the lien, they can pay the current taxes and make 18% on all of the subsequent taxes that they pay, and when the lien is redeemed they will also receive a hefty penalty on the certificate amount (6%). And as another bonus, in certain municipalities, if they more than $10,000.00 in subsequent taxes for the year, at the end of the year another 6% penalty will be added to the subsequent taxes that they paid. So for instance in the case of this particular lien, the annual taxes were around $68,000.00, (this was commercial property assessed at over 2 million). If they held the lien for a year and it redeemed, they would be able to pay in another $68,000.00 and make 24% (the 18% plus the 6% year end penalty) on that. Although they got 0% interest on the certificate amount, they still get a 6% penalty on it, so their total profit would be $17,640.00 on a total investment of $295,000.00, for a yield of 5.98%.

What I didn’t understand is why would someone pay a few hundred dollars for a small sewer lien with no open taxes. Some people see all the money that is bid for larger liens and think that they can apply the same percentages to smaller ones, but it just doesn’t work. A newbie investor paid $1000.00 for a small sewer lien that was a little more than $200. In this case it doesn’t really matter what the annual taxes are, since you will not get a chance to pay them. You may be able to pay the subsequent sewer amounts, but that is probably no more than $500.00 per year. And because the delinquent tax amount is so low (under $1500.00) the penalty that you receive on the certificate amount is only 2% and the interest received on the subsequent sewer payments will only be 8% until the delinquent amount reaches $1500.00. It would take you almost three years to pay enough subs to reach that amount and most sewer liens will pay off within the year. But in this case let’s assume that the lien will be held for one year and then redeem like we did in the example above and see how the investor does.

If the lien redeems in a year the investor will get back their $1000.00 premium – with no interest or penalties along with the redemption amount. Lets say that sewer tax is $500.00 per year and they paid the subsequent taxes for one year. They would receive back the certificate amount with no interest and a 2% penalty, which is only $4.00 and the subsequent sewer amounts that they paid with 8% interest, which is $40.00. So their total profit would be $44.00 and their total investment was $1700.00, giving them a yield of 2.3%. Right now they could get more than that in the bank without doing any work. But most sewer liens redeem in a few months, so it is not likely that an investor will even to that well.

These examples are a little simplified and it doesn’t work out exactly this way. In New Jersey taxes are paid quarterly, so instead of paying the taxes all at once, you pay them 4 times a year. So the actual returns are a little lower than the examples here, simple because you usually don’t get to pay a whole year of subsequent taxes at one time. But the moral of this story is “know what you’re bidding” when you go to a tax sale.

In this case the newbie investor did not know that she wasn’t going to receive any interest on the premium that she was bidding, or on the certificate amount. She really did not know what she was doing, but she kept bidding because other investors were also bidding. Sometimes seasoned investors continue bidding because they want to bid new investors up to the point where it is not profitable for them. Their reasoning is that they think they are getting rid of the new competition. And some investors that are bidding with fund money, or appropriated funds, must use a certain amount of money per year, so sometimes they pay more than they should for liens. Don’t let them bid you up to numbers that don’t make any sense.

Know what your bidding before you bid at a tax sale. It you’ve never been to a tax sale before, you might want to go and observe what happens before you actually bid. After the sale, if there’s something that you don’t understand, ask someone in the tax office. Different states have different bidding procedures. In some states the interest is bid down, and in other states premium is bid for liens. New Jersey is the only state where interest is bid down and premium is bid. So a lien can go quickly from 18% to $1800.00 in premium with no interest.

1 comment:

Jeff said...

Very helpful. Thank you.