AZ Property Tax Lien ALERTS

November 5, 2002 - Comparing tax lien buying strategies

Importance of Subtaxing & Prompt Foreclosures

By Mark L. Manoil, Phoenix

Through recent discussions with our clients we have identified different investment strategies about the best ways to buy tax liens. I have long advocated that a buyer seek liens on parcels that do not have separately-certificated earlier-year liens, that the lien buyer conscientiously pay subsequent delinquent taxes ("subtaxes") on the property, adding them to the tax certificate, and that the investor initiate foreclosure as soon as the lien ripens for foreclosure. After discussing competing approaches, I give my reasons for my position, as a lawyer who processes the foreclosures.

Some investors prefer to buy single-year tax liens, and not purchase the subsequent delinquent taxes. They give several reasons for this approach: (i) it allows them to spread their money around and "touch" as many different parcels as possible; (ii) to the extent any parcel is poor security, they diversify the risk of their tax lien portfolio; and (iii) because approximately 85% of tax liens are redeemed within three years after sale, subtaxing would be investing more money on an unredeemed lien, which is by definition more likely not to be redeemed – thus decreasing the likelihood of turning over the cash flow and possibly reinvesting for compounding of returns. And why foreclose as soon as possible, if the lien has a good interest rate compared to what’s available in other investment alternatives?

This reasoning may make good sense for the investor aiming primarily for interest return, and not foreclosure. But regularly subtaxing can increase return, and more importantly, perhaps, decrease risks, among other benefits.

Increase Returns. Tax liens earn interest on a simple interest basis, so after one year the interest return degrades over time if calculated on a compounded interest basis. That is, if you figure out the effective compounded rate from the time of initial purchase to the time of ultimate redemption, it will be a number less than the face bid rate if the lien is held more than 12 months, because there is no actual compounding on the interest earned from the lien. This analysis is useful for comparing returns in tax liens to other available investments.

For example, if you bought a $1000 lien at auction at 16% and did not subtax it, it would be worth $1160 after one year, $1320 after two years, $1480 after three years, $1640 after four years, and so on. At the end of the first year, you have actually earned 16% on the investment. If considering each year as a separate earning period, after which earnings are reinvested, it is possible to determine what the effective compounded rate of interest earned over the life of the investment is. What rate is earned, on an annual basis, when the initial investment was $1000 and the payoff after four years is $1640? My financial calculator indicates the answer is 13.165%. If held an extra year, so that the payoff is $1800, the compounded annual rate earned is 12.475%.

Obviously, the pattern holds true for all bid interest rates, so that if the original certificate was 8%, using our example, total interest earned over 5 years would be $400; the internal rate of return on an annual compounded basis, would be 6.961%.

If subtaxing, the later year subtaxes will probably be out a shorter time than the first year’s investment, so those later-year purchase returns, stated in similar terms, will be higher, and will actually drive up the internal rate of return on the overall lien investment when the returns from the separate year tax purchases are blended together.

The CP Disposition Worksheet discussed in Chapter 12 (and template provided in Appendix I-2) of Arizona Property Tax Liens - Guide to Profit, Protection and Prosecution (available at cpexchange.com) explains how to set up a spreadsheet to measure the actual internal rate of return on a lien investment, whether only one year is purchased or several years of subtaxes are also paid.

Reduce risks. Other tax certificate holders have a right to redeem. Arizona Revised Statutes, Section 42-18151. Thus, excluding them by paying the subtaxes reduces the risk of redemption coming from another tax lien holder. Having a single-year tax lien that is foreclosable may result in a more complicated foreclosure – at least more tactical decisions will be required: should other year tax lien holders be sued so that if they do redeem they are liable for fees and costs, or should the other year tax liens simply be paid off before filing suit? These concerns can be avoided simply by subtaxing up to the date of foreclosure.

If the foreclosure is successful, the lien holder will have to pay off the other tax liens on the property anyway, because no one lien year can extinguish the liens of other year liens on the parcel. A.R.S. Sec. 42-17153; Bauza Holdings, L.L.C. v. Primeco, Inc., 199 Ariz. 338, 18 P.3d 132 (App. 2001). If paying those other years as subtaxes instead of after foreclosing, the investor can avoid having to pay as much in interest on redeeming the other year liens.

Leverage. Subtaxing increases the size of the tax lien, and may therefore increase the likelihood that the delinquent property owner cannot pay the full amount when foreclosure is filed. This increased leverage in foreclosure increases the likelihood of obtaining the property. On the other hand, the single-year lien buyer admittedly enjoys a greater lien-to-property value ratio, but at the price of higher risk of being redeemed.

Assignability. A fully-subtaxed lien, which has effectively excluded other tax liens from existing on the parcel, is also more attractive to a potential lien buyer. If it is the only tax lien on the property and it is ripe for foreclosure, another party with a specific desire or need for the property may be willing to purchase the tax lien at a premium (i.e., for more than its current redemption value), just to have the opportunity to use the lien in foreclosure. We have often seen parties use tax lien foreclosure as a mechanism to clean up a very clouded title. An old single-year tax lien if offered for assignment may not fetch full redemption value, because of the foreclosure complications that accompany it.

Prompt foreclosure when the lien matures is recommended for several reasons: by foreclosing sooner rather than later, the aggregate amount of accumulated back taxes on the delinquent property can be kept to a minimum; the investor therefore enjoys a better lien to property value ratio; from a public policy point of view, the property is returned to the active tax roll sooner.

In contrast, those investors who sit indefinitely on their liens after they have ripened for foreclosure incur unnecessary risks: they must invest more in subtaxes, or allow other lien positions to be taken against the property; a larger amount of back taxes accumulates against the delinquent property; their interest rate of return, as described above, decreases the longer they hold the lien; and their investment is locked up, preventing reinvestment of the proceeds at potentially higher rates of return.

An investor should not bank on the "inevitability" of redemption, as we have seen many parcels that have accumulated greater tax liability than their fair market value. Under such circumstances, no lien holder has an incentive to foreclose, and take the property subject to the other tax liens.

Tax lien buyers should examine these considerations, and if they decide to continue to limit themselves to one-year positions, do it knowingly. Also, in some counties the investor may have no discretion in the matter, as the treasurer’s practice is to require only one certificate holder at a time on the parcel. These "single-certificate" counties are discussed in greater detail in Chapter 8 of Arizona Property Tax Liens. In such counties, the failure to pay subtaxes may be the equivalent of a one-year exit strategy, as the treasurer will re-offer the lien at the next year’s auction – and if it is purchased the original lien holder’s certificate will be assigned and the lien holder will receive what looks like a redemption.

Reminders:

Mark L. Manoil
Carson Messinger Elliott Laughlin & Ragan, PLLC
3300 North Central Avenue, 19th Floor
Phoenix, AZ 85012
602-264-2261

Arizona Property Tax Lien Primer: http://members.cox.net/manoil

 The information presented in this communication is not intended as legal advice, nor does this communication establish an attorney-client relationship. The opinions expressed are those solely of Mark Manoil, unless otherwise noted. I specifically disclaim any liability for any reader's detrimental reliance on the information and views presented herein. If you need professional advice, please contact a competent professional.

© 2002 Mark L. Manoil

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