Would you want to try to collect against this homeowner? Image: J.B. Hill via Flickr.

Tax liens are every taxpayer's nightmare, as a successfully filed lien can pave the way for the government to foreclose on your home or repossess other property. For investors, though, tax liens can be an opportunity to make money, as purchasing a tax lien from a government entity can give you the right to levy against a delinquent taxpayer's property and potentially recoup the amount you pay the government plus a healthy profit. Let's take a closer look at tax liens and how they can affect taxpayers and investors in different ways.

What tax liens are
Tax liens enable a government entity to secure an interest in property held by a taxpayer who fails to pay taxes when due. For the federal government, tax liens can arise from non-payment of any type of taxes, including not only income tax, but also gift and estate tax. At the state and local level, tax liens for failing to pay property taxes are most common, but delinquent income tax, business taxes, or other types of tax can also bring about a lien.

The priority given to a tax lien against other creditors depends on the type of lien and the governing law. The IRS generally files a Notice of Federal Tax Lien in the records of the local government where the property is located, giving it a perfected security interest that takes priority over future encumbrances on the property. State and local law often gives tax liens priority status over other creditors even if the lien took effect after other creditors filed their interest in the debtor's property.

It's important to recognize, though, that a lien by itself doesn't allow the government to take your property. It only provides the right to start whatever legal proceedings are available. For the IRS, the next step following the establishment of a tax lien is a Notice of Intent to Levy, in which the levy is the actual act of taking possession of the property under the tax lien. Local laws vary but often give the government the right to foreclose on real estate or take possession of property by following set procedures.

How to resolve a tax lien
If you're a delinquent taxpayer and the government files a tax lien against your property, the easiest way to get rid of a tax lien is to pay the back taxes owed. If you can't do that, the IRS might be willing to work with you to establish an installment plan agreement for future payment, sometimes in conjunction with a compromise amount that can reduce your total taxes owed.

However, having a tax lien on your credit report will hurt your ability to obtain credit, as potential lenders will see it as evidence of past financial trouble. Therefore, you might want to consider challenging the filing of the tax lien in the first place. With IRS tax liens, you have 30 days to file an administrative appeal to request reconsideration of the filing. If you win this collection due-process appeal, you might avoid having the tax lien show up in your credit history.

Investing in tax liens
Some investors have discovered that investing in tax liens can be a lucrative way to get bargains in the real estate market. Many local governments will auction off tax liens, collecting money up front without the expense and effort of jumping through the procedural hurdles to levy on the property of delinquent taxpayers.

By buying a tax lien, the investor essentially takes the place of the government, becoming a creditor of the delinquent taxpayer and having the same rights the government held. In some cases, owning a tax lien entitles the investor to regular interest payments. If the taxpayer doesn't pay, then the lien holder might be able to foreclose on the property.

Investing in tax liens isn't a guaranteed way to make money. The taxpayer usually has the right to redeem a tax lien simply by paying the outstanding amount due. If you bid more than that amount in a tax lien auction in hopes of taking full possession of the property, then lien redemption can result in a net loss. Moreover, the expenses of collecting against a tax lien can be considerable, with attorney costs, court filing fees, and other expenditures eating into any potential profit and making it a dangerous investment prospect.

If you don't want to do that work yourself, there are investment funds that invest in tax liens. Most of these funds are only available to accredited investors with high net worth and annual income. When done well, though, these funds can produce higher returns than more traditional fixed-income investments.

For taxpayers who are late making payments, tax liens are the worst possible news. Yet some real-estate investors have turned tax liens into a profit-making opportunity. Knowing about tax liens can help you ensure you are not snared by the tax trap they represent while being aware of possible lien-related investing options in the real estate arena.