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How to Make Money Investing in 0% Tax Liens

by Ankit Duggal on January 21, 2014 · 4 comments

  
Make Money Investing in 0% Tax Liens

I recently attended a meetup of BiggerPockets members in New York City and this post is inspired from a discussion at the event. First, I want to thank Darren Sager for organizing the event, Brandon for attending, and getting an opportunity to meet a lot of the fellow BP members in person. Now back to the article.

The discussion arose as a fellow BP member asked me “What do you invest in Ankit?” I stated Tax Liens are my preferred investment class for 2014. The astute BP member then stated: “How can you make money in NJ Tax Liens with everyone bidding the liens down to 0% or paying a premium to the face value of the lien?”

I explained my investment model rationale to him and I was on my way. On the bus ride back to New Jersey, I thought that was a really good question and it warranted an article to flush out the investment rational and model behind buying 0% Tax Liens.

Simple Answer- Why Buy at 0%?

Large investors i.e. private equity groups, family offices, hedge funds etc. have discovered tax liens and have driven the demand for liens beyond the available supply in certain townships. These investors are willing to accept a zero percent interest rate on initial investment in order to acquire the rights to accrue 18 percent interest on all future taxes paid on the lien.  Aside from the higher returns generated on subsequent taxes, investors earn penalties between 2 to 6 percent even if the interest rate is bid to 0 percent. This method of tax lien investing is built on the business model assumption that liens on average will not be redeemed for at least 2 years.

Case Study Answer

When I started investing in tax liens back in 2011, I attended my first tax lien auction and I noticed major tax lien investors buying liens at 0% or even paying premium to the face vale of the lien. I walked away from my first rattling my brain to figure out why would anyone want to buy a tax lien at 0%! I started researching into the asset class and realized that one of the key aspects of investing in tax liens is to keep paying subsequent taxes aka subs after buying the initial lien.

Once a tax lien investor owns the initial lien then the investor has the right to pay subsequent taxes. The ability to pay subs is important for a tax lien investor as it increases the amount of money invested in 18 percent and preserves the first priority status of the lien. Hence a zero percent initial lien purchase can become a double-digit return investment with the help of subs.

Numbers Don’t Lie

Investment Model: Purchase a lien at zero percent and pay subsequent taxes to achieve a 10%+ return over a 36 month investment horizon

The model is premised on the rationale that even liens purchased at 0 percent will achieve attractive returns through the payment of subsequent taxes.

Dates

 Amount

 Cum. Amount

Interest Rate

Accrued Interest

Cum. Interest

Rate of Return

Initial Purchase

2/1/14

$2,000.00

$2,000.00

0%

$-

$-

0.0%

Premium

$2,000.00

0%

$-

$-

0.0%

Penalty

$2,000.00

2%

$40.00

$40.00

2.0%

Subsequent Taxes

2/1/15

$2,000.00

$4,000.00

18%

$360.00

$400.00

10.0%

Subsequent Taxes

2/1/16

$2,000.00

$6,000.00

18%

$360.00

$760.00

12.7%

Subsequent Taxes

2/1/17

$2,000.00

$8,000.00

18%

$360.00

$1,120.00

14.0%

Redemption

2/15/17

Assumptions
2% Penalty for the case study example

 

The chart above shows even a tax lien purchased at the auction for 0% will throw off a 14% gross return across a three-year investment period. The premise of the investment model is based on paying $2,000 per year after the initial auction. This model only works if three assumptions hold: 1) tax lien holder continues to pay subsequent taxes, 2) the lien does not get redeemed before the third year mark and 3) the property owner does not pay the subsequent taxes on a quarterly basis.

Lets look at the returns and risks of this investment model:

Returns

2/1/14

2/1/15

2/1/16

2/1/17

2/15/17

Cash Outflow

 $(2,000.00)

 $(2,000.00)

 $(2,000.00)

 $(2,000.00)

 $-

Cash Inflow

 $9,120.00

Total

 $(2,000.00)

 $(2,000.00)

 $(2,000.00)

 $(2,000.00)

 $9,120.00

Gross Returns

$1,120.00

Gross Yield

14.0%

IRR

8.6%

 

Risks

All the risks as indicated in my previous article relating to investing in the tax lien asset class will still apply but a new risk rears it head within this specific investment model:

  1. Zero Yield Traps: Zero Yield Traps as I like to call them are tax lien certificates that you buy at zero percent wherein the property owner keeps paying the subsequent taxes without redeeming the original lien.  When this occurs the tax lien holder is stuck with their original capital invested at zero percent interest rate. The good thing is that there is no capital loss risk to the tax lien investors original principal especially if the holder has mitigated for other systematic risks associated with the tax lien investment. However, the tax lien holder is stuck in a zero percent investment with which they can do one of two things: which they can either sit and wait to receive their capital back or sell the lien at a discount to its face value to another investor.

Buying liens at zero percent interest rate can be a profitable venture if you utilize the right business model.

Download the Free Tax Lien Investment Model (http://www.biggerpockets.com/files/user/aduggal/file/tax-lien-investment-model) to help you analyze your next tax lien utilizing the subsequent tax investment model.

Happy Investing!
Photo Credit: Unhindered by Talent

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{ 4 comments… read them below or add one }

Sharon Tzib January 21, 2014 at 2:14 pm

Very enlightening, Ankit. I would imagine Zero Yield Traps are rare, no? I mean, assuming the homeowner knows there’s a lien on their property (and they should), why would someone pay their property taxes and then not redeem the property?

Reply

Ankit Duggal January 21, 2014 at 7:25 pm

Zero Yield Traps can happen, but they are rare. The owner will pay the subsequent as they may not want to have the lien get bigger by adding more delinquent taxes to the pot while they figure a way to gander the cash to redeem the tax lien certificate at some point in the future.

Reply

Jerry K. January 22, 2014 at 5:26 am

Ankit,
Very interesting to read your posts about tax lien investing out East. It’s very different, in terms of procedures, compared to tax lien investing elsewhere. I invest in Arizona liens and if you bid zero percent and win the lien, the subsequent taxes (3 year redemption period in AZ) will earn you the same as your original rate. So a play at 0% will not yield anymore over the years. A 0% play is a bet that you will be able to foreclose on the property.

If however, you don’t pay the sub taxes in AZ (except Maricopa county), then the lien goes back into the next year auction and a new investor might be able to win it with a bid that actually pays interest. Statutes for lien investing are so important to understand – even at the county level and sometimes city level.

Reply

Susan Cain January 24, 2014 at 7:13 pm

Clearly, it is important to understand the different rules in each state. In Florida, the minimum bid, with most competition, is .25%. However, all redemptions are at a minimum of 5%. When I first moved to Florida, in 1998, auctions (at the courthouse) attracted relatively few people – primarily contractors, looking to fix and flip. Now I’m seeing mostly big companies, who seem not to do any research. They simply bid on all homestead properties for a 5% return on their money.

Reply

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