With a finicky stock market, tax lien investing is becoming popular. Here’s what you need to know before jumping in:

Tax lien investing can give your portfolio exposure to real estate — all without having to actually own property. The process is complicated, and novice investors can easily get burned. Here’s everything you need to know about investing in a tax lien certificate, including how it works and the risks involved.

What is a tax lien?

A tax lien is a legal claim that a local or municipal government places on an individual’s property when the owner has failed to pay a property tax debt. The notice typically comes before harsher actions, such as a tax levy, where the Internal Revenue Service (IRS) or local or municipal governments can actually seize someone’s property to recover the debt.

How tax lien investing works

After a municipality issues a tax lien to a past-due property owner, they create what’s called a tax lien certificate that denotes how much in taxes is owed, along with interest and any penalties. To recover the delinquent tax dollars, municipalities can then sell the certificate to private investors, who take care of the tax bill in exchange for the right to collect that money, plus interest, from the property owners when they eventually pay back their balance.

Currently, 28 states allow for the transfer or assignment of delinquent real estate tax liens to the private sector, according to the National Tax Lien Association, a nonprofit that represents governments, institutional tax lien investors and servicers. Here’s what the process looks like:

1. Investors have to bid for the tax lien in an auction

Tax lien investors have to bid for the certificate in an auction, and how that process works depends on the specific municipality. Would-be investors should start by familiarizing themselves with the local area, the National Tax Lien Association recommends. Contact tax officials in your area to inquire how those delinquent taxes are collected.

Auctions can be online or in person. Sometimes winning bids go to the investor willing to pay the lowest interest rate, in a method known as “bidding down the interest rate.” The municipality establishes a maximum rate, and the bidder offering the lowest interest rate beneath that maximum wins the auction. Keep in mind, however, that as interest rates fall, so do profits.

Other winning bids go to those who pay the highest cash amount, or premium, above the lien amount.

2. The winning bidder pays the balance and handles foreclosure proceedings

What happens next for investors isn’t something that occurs on a stock exchange. The winning bidder has to pay the entire tax bill, including the delinquent debt, interest and penalties. Then, the investor has to wait until the property owners pay back their entire balance — unless they don’t.

Most homeowners have a so-called “redemption period” — what’s generally one to three years — before they’re required to pay the taxes plus interest in full. But if the homeowner doesn’t return the tax debt, the tax lien investor is the one responsible for kickstarting the foreclosure process, which would allow the investor to assume ownership of the property. If you win a lien at auction, you must also learn your responsibilities. For example, in Illinois, within four months of purchasing a lien, you’re required to notify the property owners that you possess the lien and can foreclose if they don’t repay, says Joanne Musa, a tax lien investment consultant and founder of TaxLienLady.com. Then another letter must be sent before the end of the redemption period.

Benefits and risks of tax lien investing

It is best to think carefully about the risks involved before jumping into tax lien investing. While some investors can be rewarded, others might be caught in the crossfire of complicated rules and loopholes, which in the worst of circumstances can lead to hefty losses.

1. Tax liens can be a higher-yielding investment, but not always

From a mere profit standpoint, most investors make their money based on the tax lien’s interest rate. Interest rates vary and depend on the jurisdiction or the state. For example, the maximum statutory interest rate is 16 percent in Arizona and 18 percent in Florida, while in Alabama the rate is fixed at 12 percent, according to the National Tax Lien Association.

Profits, however, don’t always amount to yields that high during the bidding process. In the end, most tax liens purchased at auction are sold at rates between 3 percent and 7 percent nationally.

2. Tax liens come with an expiration date

If the property owner fails to pony up the property taxes by the end of the redemption period, the lienholder can initiate foreclosure proceedings to take ownership of the property. But that rarely happens: The taxes are generally paid before the redemption date. Liens also are first in line for repayment, even before mortgages.

Even so, tax liens have an expiration date, and a lienholder’s right to foreclose on the property or to collect their investment expires at the same time as the lien.

After you’ve bought a lien, you may also want to pay taxes on the property in the years that follow, so no one else can purchase a lien and thus have a claim on the property.

Don’t think you can just buy and forget about it.

3. Tax lien investing requires thorough research

Individual investors who are considering investments in tax liens should, above all, do their homework. Experts suggest avoiding properties with environmental damage, such as one where a gas station dumped hazardous material. One reason for this: In the event of foreclosure, the property would be yours.

You should really understand what you’re buying. Be aware of where the property is, the neighborhood and values, so you don’t buy a lien that you won’t be able to collect.

Would-be investors should also check out the property and all liens against it, as well as recent tax sales and sale prices of similar properties. If a property has other liens, that might make it harder to gain its title in the event of foreclosure.

Yet, keep in mind that the information you find can often be outdated.

People get a list of properties and do their due diligence weeks before a sale. Half the properties on the list may be gone because the taxes get paid. You’re wasting your time. The closer to the date you do your due diligence, the better. You need to get an updated list.

Bottom line

Because tax lien investing involves so much due diligence, it might be worthwhile to consider investing passively through an institutional investor who is a member of the National Tax Lien Association for 80 percent of tax lien certificates are sold to members of the NTLA, and the agency can often match up NTLA members with the right institutional investors. That might make managing the process easier, especially for a beginner.

While tax lien investments can offer a generous return, be aware of the fine print, details and rules.

We’ve had a few clients and friends who have invested in tax liens on a big-time basis almost as a business and have done well. But it’s complicated. You have to understand the details.