Cap on Tax Sale Interest

I witnessed some surprisingly high bids today at a tax auction.  People, if your goal is redemption income, there is a limit on the amount of interest you can earn!!  If you bid too much, then part of your bid earns 12% per year interest, and part earns 0% interest. The more of your money earns 0% interest, the more it drags down that 12% to something smaller.  Today, I saw an effective interest rate of only 1.42%

If there is a bidding war, the winning bid will have two portions. One is the actual taxes due. The other is the overbid amount.  Let’s say the taxes are $681 and the overbid is $19,319, for a total winning bid of $20,000.

The taxes earn 12% per year. That portion of the overbid that is equal to, or less than, 15% of the tax appraised value of the property, earns interest.  For purposes of our example, let’s assume the property has a tax appraisal of $67,000.

Fifteen percent of $67,000 is $10,500.

Of the $19,319 overbid, only $10,500 will earn 12% interest.  $8,819 will earn no interest.

Let’s assume the taxpayer redeems after exactly one year. We will disregard the fact that another year’s taxes will be due. We’ll just pretend that is not the case.  I want the numbers to be easy for this example.

After one year, the taxpayer will owe interest of $81.72 on the unpaid taxes.  He will owe $1,260 interest on the qualifying portion of the overbid ($10,500 x 0.12 = $1,260).  That is a total of $1,341.72 total interest.

On the other hand, the investor wrote a check for $20,000 and earned only $1,341.71 of interest. When you divide $1,341.72 by $20,000, that results in an effective interest rate of 6.7%

Bidding too much is how some investor at today’s auction ended up with an effective interest rate of only 1.42%  Perhaps that investor really wanted the real estate, but his bid was more than the tax appraised value!  Please do your math homework before bidding.