Tax Liens Promising 18% Returns May Be a Case of ‘Buyer Beware’

After Brian Finkelstein first heard about tax-lien investments three years ago, the former bond trader found the potential for 18 percent returns so compelling he jumped into the business full-time.

Like other investors, Finkelstein, chief executive of Broad Financial LLC in Monsey, New York, is hunting for yield as the Federal Reserve indicates it may keep interest rates “exceptionally low” through 2014. Yet high fees, illiquidity and a lack of transparency are a few of the pitfalls investors may encounter with private funds that buy claims to delinquent property taxes, said Alan Zafran, a partner with Luminous Capital.
Enlarge image Tax Liens Promising 18% Returns May Be a Case

An unfinished house, fenced and abandoned, in Hinsdale, Illinois. Photographer: Chuck Berman/Chicago Tribune/MCT via Getty Images
Enlarge image Tax Liens

Carl Smith, tax collector for the town of Orange, second from right, prepares to record payments from winning tax-lien auction bidders, lined up at left, at the municipal building in Orange, New Jersey. Photographer: Emile Wamsteker/Bloomberg

“It’s caveat emptor: Buyer beware,” said William Waller, a Washington-based real-estate lawyer who has worked on about 2,000 to 3,000 tax-lien cases, referring to the fact that jurisdictions that sell the liens generally don’t guarantee the condition or market value of the properties.

Tax liens, or tax certificates, generally are sold to investors at auctions and are secured by claims on the underlying real estate that take priority over mortgages. Interest generally accrues on the taxes owed at rates set by auction, which property owners must pay to clear up the debt. If they don’t, an investor who bought the lien may foreclose on the property.
Market Size

About $7 billion to $10 billion in delinquent property taxes are sold to investors annually, according to estimates by Trace Platform LLC, which provides clearing, transfer and escrow services for tax-lien trades and isn’t related to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Counties and cities in 28 states and Washington, D.C., sell the liens to investors, according to Brad Westover, executive director of the Jupiter, Florida-based National Tax Lien Association, a membership group for tax-lien investors and servicers.

The certificates generally are regulated by the states, Waller said. Rules on maximum interest rates, waiting periods before a foreclosure may proceed, how fees and interest are assessed on the debts and how auctions are conducted vary among jurisdictions, said Tom McOsker, head of the tax-receivables brokerage unit for New York-based GFI Group Inc. (GFIG), which runs a secondary market for the certificates. Florida auctions the certificates online, and the District of Columbia holds live bidding. In New Jersey the maximum interest rate a lien may accrue is 18 percent, and in Iowa it’s 24 percent.
New Jersey Auction

At an auction in December, bidders on a first-name basis with one another chatted in the aisles and cracked jokes as they trickled in to the second-floor courtroom of the municipal court in West New York, New Jersey. In the hour leading to the auction some bidders, a few wearing wireless headsets and hunched over laptops, combed through lists of the more than 400 liens up for sale with highlighters.

Kerri Tierney-Campen, the tax collector for the Town of West New York, began the auction by calling out liens that were no longer available because they’d been paid off that morning. The liens up for auction ranged in size from $189 in taxes owed to one debt of $105,478. Once bidding started, potential investors called out the interest rates they’d want to earn on each lien, with bids starting at 18 percent and then moving lower. About 20 people attended, including about 13 bidders.
Tax Treatment

Average returns for tax-lien funds aren’t available, GFI’s McOsker said. A diversified portfolio of “quality” assets, meaning liens that redeem before the waiting period is over and before the buyer may foreclose, could return about 6 percent to 9 percent annually, he said. Most tax-lien funds sell shares directly to investors, rather than going through a broker- dealer, he said.

The tax treatment of profits and losses on tax-lien investments varies, depending on several factors, said Eric Smith, a spokesman for the U.S. Internal Revenue Service.

Investors may be better off buying shares in certain bond mutual funds that invest in mortgage debt, such as DoubleLine Total Return Bond Fund (DLTNX), said Zafran of Luminous Capital, which manages about $4.7 billion for individuals and families, and doesn’t own tax liens.

The DoubleLine fund had about 83 percent of assets in mortgage-related securities as of December, according to the fund’s website. It returned 9.2 percent in 2011, according to data compiled by Bloomberg. High-yield corporate bonds, or those rated below investment grade, returned about 4.4 percent in 2011, as measured by the Bank of America Merrill Lynch U.S. High Yield Master II Index, Bloomberg data show.
‘High Fees’

“You have limitations on when and if you can pull your capital” from a private fund, Zafran said. “And you’re going to be subjecting yourself to a high set of fees.”

Finkelstein, 52, who traded bonds and derivatives for 15 years prior to starting his company, now manages private placements that invest in the liens. When buying into one of Finkelstein’s funds, investors generally must commit to locking up their money for a certain period of time, such as one year. After that point the funds begin to distribute cash to investors as liens are paid off, a process that may take about 1 1/2 years to complete, Finkelstein said. Because the funds don’t liquidate until the last lien or foreclosure in the portfolio is paid off or resolved, there’s no precise certainty as to when investors will get all of their cash back.
Accredited Investors

Finkelstein said after fees, which are 2 percent annually plus 20 percent of gains, one of the funds he manages returned about 8 percent in 2010. Returns aren’t yet available for 2011 and as of Aug. 1 the fund was on track to earn about 7 percent for the year, he said. The funds are available only to accredited investors, which generally means individuals with assets of greater than $1 million, excluding a primary residence, or earning more than $200,000 annually.

Finkelstein invests primarily in New Jersey and said he mostly buys liens on single-family homes in more affluent areas, where he said the certificates are backed by stronger collateral and there’s less of a chance a lien will go to foreclosure.

“More than 99 percent of the time the bank will pay you off,” rather than allow a foreclosure to proceed, if a homeowner hasn’t paid the taxes and the property hasn’t dramatically depreciated, he said. That’s because the lien can wipe out a mortgage of greater value.
Distressed Properties

“If you have a $100,000 property and a $2,000 tax bill -- well good heavens -- no one’s ever going to walk away from a $100,000 property for $2,000, if the value truly is $100,000 and the property is still standing,” Westover, of the tax-lien association, said.

One risk with purchasing liens on distressed properties is that between the time an investor buys the certificate and the date they could foreclose, additional taxes and assessments can add up even as the value of the property may fall.

Some certificate buyers have seen their investments go underwater, meaning the value of the liens exceeds the value of the real estate, as property values have declined, said John Reid, an attorney with Tobin, O’Connor & Ewing in Washington.

“You’re investing today on a lien-to-value ratio and hoping it either stays the same, or appreciates,” Reid said.

Nationally, lien-to-value ratios average less than 10 percent, McOsker said. Those ratios may afford investors a margin of safety, yet tax-lien investors generally must pay off additional liens that have accrued on a property, such as for unpaid water bills, additional property taxes or related fees from the county or municipality, to complete a foreclosure, Waller said.
Bankruptcy Priority

Liens for taxes owed to the IRS generally take priority over liens for property taxes in a bankruptcy, said Donald Dinan, a partner with Roetzel & Andress in Washington and general counsel for the association of lien investors. Homeowner bankruptcies generally halt the progress of foreclosures and can tie up investors’ money for years, Reid said.

If there are multiple tax liens and multiple investors attached to a property, generally the buyer with the earliest certificate has the right to foreclose first, with rules varying by jurisdiction, Dinan said.

A certain portion of lien sales get voided after an auction because the taxes were improperly assessed, Reid said. In some areas, such as Washington, D.C., the jurisdiction pays the purchaser interest owed on voided certificates and in some, including most parts of Maryland, they don’t, Dinan said.

Ruben Rodriguez, 37, who lives in West New York, attended the December auction and said he was there to learn.
‘Safe Investment’

“I definitely want to invest in my own neighborhood,” he said. Rodriguez works in New York City as a billing manager for the Mount Sinai Medical Center, he said in a telephone interview after the auction. He said he’s attracted by the potential to acquire properties for less than 10 percent of their values, if the liens go to foreclosure.

“If you know what you’re doing and you’re buying properly it’s a relatively safe investment and gives you an outsized yield, compared to what else would be available in the marketplace,” said Albert Friedman, who manages about $60 million in a tax-lien fund for Boca Raton, Florida-based Alterna Capital Management, which bid at the West New York auction in December. “You have to be big enough to attend a number of auctions, buy a number of certificates and have people on the ground,” Friedman said. He declined to comment on the fund’s returns or redemptions policy, citing regulatory restrictions on advertising by private placements.
EBay Store

When institutional investors want to unload a lien prior to foreclosure they may sell it to a specialist such as Dan Friedman, managing member of Elmhurst, Illinois-based Optimum Asset Management LLC. In addition to managing about $15 million in liens on behalf of family offices and other investors, Friedman’s firm sometimes negotiates directly with homeowners to come up with a payment plan, and in other cases forecloses and then resells the properties.

“We move a fairly high volume of foreclosure properties online,” through the firm’s store on the EBay Inc. (EBAY) website, which on Feb. 7 had two properties listed for sale, including a single-family home in Cleveland with a current bid of $920.

Investors considering putting money into a tax-lien private placement should take precautions to ensure they’re not the victims of fraud, said Andrew Altfest, executive vice president of Altfest Personal Wealth Management, a New York-based investment adviser that manages about $800 million on behalf of individuals and families.
Investor Precautions

“You’re investing with a private fund that’s not going to have the same amount of regulation,” as securities offered to the general public such as mutual funds, Altfest said. Investors should “make sure that the fund has a reputable auditor,” and an administrator who signs off on every transaction, he said.

Investors should check the background of tax-lien fund managers with their state securities regulator before investing, said Jack E. Herstein, assistant director of the Nebraska Bureau of Securities.

Since 2008 at least six individuals have pleaded guilty to conspiring to rig bids at New Jersey and Maryland tax-lien auctions, according to press releases from the U.S. Department of Justice. The Justice Department continues to investigate the auctions, said Gina Talamona, a spokeswoman.

“At an open outcry auction there’s always the possibility of three guys hunkered around the water cooler talking about what they’re interested in,” Westover said.

JPMorgan Chase & Co.’s Xspand unit received a subpoena as part of a Justice Department investigation in 2009, according to a prospectus for New York City tax-lien bonds serviced by the firm. The firm announced in July it would begin exiting the business. Jennifer Zuccarelli, a spokeswoman for the New York- based bank, declined to comment on the subpoenas.

“The beautiful thing I’ve learned over the years is: Delinquent taxes never go away,” Westover said. “Even in a good economy, there are still delinquent taxes.”