Tax Sale Investing: Preventing Fallout on Other Lienholders

By Randall L. Saunders, Matt Abee, Carl Fumarola, and Megan Fitzgerald

Tax sale investing offers the potential for an attractive return on a secured investment and an extension for property owners to avoid losing their homes due to a property tax delinquency. With attractive interest rates set by statute, a lien on real property to secure the investment and a second chance for property owners to cure the delinquency, tax sales seem to offer a win-win. But where does this leave others with an interest in the property?

Investing in tax liens and deeds is not without risk, especially to pre-existing lienholders. This article is the final piece in a series of five explaining tax sales, why financial institutions with an interest in real property must actively monitor the jurisdiction’s tax sale laws and monitor for competing claims to protect their interests. As a summary, this article explores what lienholders need to do to protect lien interests from tax sales.

Tax Sale Investing: What Happens When a Tax Sale and Mortgage Lien Mix

Tax sales can have serious implications for anyone with an interest in the property, such as holders of a mortgage or deed of trust. Just as tax sale investors should be familiar with the tax sale laws in the jurisdiction where the tax-delinquent property is located, institutions holding or servicing mortgages should also understand the effect a tax sale could have on their interest in properties securing their mortgage. Depending on the jurisdiction, the issuance of a tax deed could wipe out a mortgage, eliminating the financial institution’s security for the loan. It could also lead to liability for the mortgage holder or servicer under consumer protection statutes.

Tax sale investors, mortgage lienholders, and anyone else with an interest in the real estate should regularly monitor local records for competing interests and claims that could affect their interest in the property. Often the requisite notice to lienholders is minimal and ineffective, especially if the lienholders address on the recorded instruments is outdated. A lack of due diligence at any stage by an investor, other lienholder, or property owner could unnecessarily reduce an interest to zero.

What Are Tax Sales?

Tax sales developed as a way for local government to collect delinquent taxes. Those taxes are used to pay for necessary community services such as schools, safety personnel and equipment, and are used to provide utility services. Tax sales also offer delinquent property owners an opportunity to finance the tax delinquency, buying them more time to satisfy the debt.

When a property tax bill is delinquent, the local government may auction off a tax lien or a tax deed to collect the delinquent property tax. A tax lien is a recorded lien interest in the real property for which tax is delinquent. The property owner may redeem the property, eliminating the lien, by repaying the tax lienholder the auction price plus interest and costs. In some tax lien jurisdictions, the holder of a tax lien may take steps to foreclose on rights of any others in the property and request the issuance of a tax deed.

Similarly, a tax deed gives the tax sale purchaser ownership of the property, but, again, the original owner may redeem the property by repaying the deed holder the auction price plus interest and costs. In tax deed states, the purchaser of a tax deed may be able to clear title to the property after waiting for the prior owner’s redemption rights to expire.

In both cases, failure to redeem the property within a window defined by state law terminates the original owner’s rights to the property. In most states, if an owner loses its rights in the property, so does any other party holding a mortgage or lien on the property.

Tax Sale Concerns for Financial Institutions and Other Non-Investors with Rights to the Property

Banks are not typically considered to be investors in real estate, but their use of real property as collateral for secured loans puts them at the same risks as investors. The resulting mortgage liens stand in line with other recorded interests such as other mortgage lienholders, mechanic’s lienholders, and anyone who purchased an interest via a tax lien or tax deed sale. However, the resulting mortgage lien, like other liens, generally is junior in priority to a county’s tax lien—after all, the governmental entity relies on the regular payment of taxes to continue to provide government services.

When a tax sale includes real property on which a financial institution has a lien, the institution’s interest in the property is at risk. If the goal of the holder of a tax lien or tax deed is to obtain title to the property, other lienholders will face a foreclosure action or other statutory action to clear title to the property. Depending on the tax sale laws of the jurisdiction where the real estate is located, a foreclosure action instituted by a tax lien or deed holder could eliminate a mortgage lien. The loan would survive, but the financial institution would have to result to other collateral to secure payment on a delinquent promissory note or loan instrument.

How Financial Institutions Can Protect Lien Interests in Real Property

Lending institutions typically perform due diligence before extending credit to be secured by real property, including running a title search for existing liens on property. But mortgagees cannot rest easy on pre-loan investigation and record-checking. Competing liens may arise after issuance and recording of a mortgage interest. When that competing interest arises from delinquent property taxes, the mortgagee’s earlier recording time may not be enough to prioritize its lien.

Financial institutions can take steps to prevent tax sales from jeopardizing collateral. Many lenders roll property taxes into the borrowers’ loan payments and then make the tax payments on behalf of the property owners. Indeed, federal law under the Real Estate Settlement Procedures Act anticipates that many lenders will require borrowers to establish escrow accounts for things like taxes or hazard insurance. While this requires extra administrative time, it’s less cumbersome than constantly monitoring the property tax records and provides assurance that the mortgage account will have sufficient funds to satisfy a property tax lien before the property is sold at a tax sale.

Alternatively, a lender may include in the loan terms that the failure to keep current on property taxes constitutes default of the loan and would allow the bank to demand immediate payment of the remaining balance. While this option is less cumbersome initially, it nevertheless requires regular monitoring of the property tax records to watch for such a default. Upon learning that a default has occurred, the institution then must decide whether to give notice of default and start foreclosure proceedings if the property owner cannot pay off the loan. It may also require the lender to advance funds to satisfy the tax delinquency if the bank cannot foreclose before the property is lost at a tax sale.

Banks cannot rely on credit reports for tax lien information, but  services are available to investigate or monitor the relevant property tax records. Engaging these servicers lightens a financial institution’s administrative load but increases the cost to lending. Because lien protection is a priority, a financial institution often chooses the option that best fits in its current working model and passes any additional cost to the lender.

Finally, financial institutions need to continually monitor the tax sale laws in the jurisdictions in which they extend credit for real property purchases. Tax sale laws can change drastically in a single legislative session as happened in Alabama. Effective in 2019, the new tax sales law allowed each county in the state to choose whether to collect delinquent property tax through tax liens or tax sales, a shift from the entire state using the same system.

Legislative changes to tax sale laws and judicial opinions shaping the interpretation of that legislation can impact the value of a tax lien or deed by increasing or decreasing the risk that a property could go to tax sale without notice.

Avoiding the Pitfalls of Tax Sale Investing

Monitoring tax records and legislation is a tall order for financial institutions already subject to regulation from multiple areas at the federal and state level, especially if they operate in multiple jurisdictions. Avoiding easily anticipated as well as surprise circumstances requires a comprehensive understanding of tax sale procedures in each jurisdiction in which you have real estate interests.

The basic tax sale concepts to understand in each jurisdiction are these:

• What steps do local and state jurisdictions use to satisfy tax delinquencies?
• What tax sale system is used: tax liens, tax deeds, or a combination?
• What interest is conveyed at the tax sale?
• What is the deadline, if any, for confirming the interest purchased at a tax sale or initiating foreclosure proceedings?
• What is the redemption period?
• What notice is a lender entitled to of a tax sale or the end of a redemption period?
• What current or potential changes in legislation or judicial interpretation of legislation could affect your real estate interests?

Individual investors may rely for relevant information from the National Tax Lien Association (NTLA), a trade organization that serves those who invest in real property as well as government agencies. Institutions often have legal departments dedicated to learning the answers to these and other relevant questions, but consulting tax practitioners who regularly work in a particular jurisdiction can add insight not available to corporate legal departments.

In summary, tax sales offer an investment option for individuals and institutions, but full lien protection—by investors and other lienholders—requires monitoring and understanding the tax sale process and laws. Understanding the basics, monitoring for changes in legislation, and quickly identifying new interests that could affect your liens are key to making your lien investment profitable.

These materials have been prepared for informational purposes only and are not legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel.