October 11, 2021

How To Invest in a Foreign Property with a Self-Directed IRA - Part 2

Caution tips for small investors 

In Part 1 of this series we discussed two important questions: 

  • Why is a Self-Directed IRA is a good fit for foreign real estate investing? 
  • What kind of Self-Directed IRA makes these investments possible? 

In this installment, we’ll focus on caution points in the foreign real estate arena. If you’re looking to invest in an international property with a Self-Directed IRA, chances are this may be your first time on the market. That means you’ll be facing a learning curve as you get comfortable with the ins and outs of foreign investing. The best thing to do (if the opportunity is available) is to get tutored by somebody with practical experience.  This can save a lot of grief in the long run as they can guide you through potential pitfalls and make sure that you get what you’re paying for. Second, the best is to review what the experts have to say on the topic. What follows are some of the caution points that experienced investors feel are important to know before embarking. 

  1. Know your property type 
    This is solid advice for standard real estate investing, but it’s especially important when buying foreign property. Before your Self-Directed IRA goes in to look at a foreign market, you should know what kind of property you’re looking to find. This will help you from being distracted by lesser properties and will also give you a means of comparison. A typical strategy could be to look for residential properties in well populated cities that are within a 5-mile radius of a central district. 
    What this strategy accomplishes is helping to ensure that your property will be desirable. People always need a place to live and within commuting distance to their place of work is essential. Granted, you may not get the cheapest property with these criteria, but you can definitely get a viable one.  
    Obviously, the specific strategy is not important here, as much as the fact that you have a filter.  There are so many kinds of international real estate that it’s almost impossible for your Self-Directed IRA to consider random properties. By defining your property strategy beforehand, you can become an expert in a certain niche, while at the same time avoiding being tempted by offers that seem to good to be true. 
  1. Know the law 
    In the United States we’re used to anybody being able to buy any property. There is little difference between your Self-Directed IRA buying a property, your uncle buying it, or your friend from Canada. However, that’s not the case everywhere. Many countries have tight regulations that govern foreigners buying property. These regulations differ from country to country and can come in a variety of flavors. Here are a few examples: 
  • Switzerland – Property transactions are governed by the “Lex Koller” law. This is a set of regulations that highly restricts foreign ownership of Swiss property. Some of the rules include foreigners being unable to buy residential properties or land for development, but they may purchase apartments in designated resort areas.  
  • Malta – Foreigners require special permission from the government to buy property and are limited to one property per family. 
  • Thailand – Foreigners may not purchase property directly, but they may do so by establishing a Thai Limited Company. 
  1. Get clarity on tax liability 
    Taxes are always important, but in a Self Directed IRA they can be a real deal breaker.  This is because a property is often bought with the assistance of a loan, and for a Self Directed IRA, that means invoking UDFI. UDFI (Unrelated Debt Financed Income) is a tax imposed on a retirement account when it makes an investment with non-retirement funds. In the case of a property purchase, the percentage of the property that was bought with the Self Directed IRA funds would retain its tax-deferred status. However, the percentage that was financed by a loan (i.e. the mortgage,) would be subject to UDFI. The tax rate for UDFI is variable but can be as high as 37%. 
    Let’s take an example. If your Self Directed IRA purchases a foreign rental property and pays 60% with IRA funds and 40% with a non-recourse loan, then 40% of the income would be subject to UDFI. If the property earns $50,000 per year, then you would have to pay UDFI on $20,000. At a 37% rate that comes out to $7,400. That’s a significant consideration for a retirement investment. 
    There are two ways around UDFI. The first is to pay the entirety of the foreign property with Self Directed IRA funds. The second is to use a mortgage but to set up what is known as a blocker corporation. This is currently a legal strategy, although there has been a recent push to reform this loophole. With that in mind before using a blocker corporation, you should get advice from legal professionals as to its permissibility in your Self Directed IRA. 
    The way a blocker corporation works is by setting up a second business entity in a country which has favorable tax regulations. That business entity can purchase the foreign property using a mortgage. Your Self Directed IRA can then invest in that business entity and receive profits in the form of dividends. Since your retirement account didn’t make the loan, it will not be subject to UDFI.  
  1. Be aware of additional taxes and fees 
    There are a host of taxes and fees that can be imposed on real estate, and some of them may even be specific to foreign investors. Here are a few of the more common ones that you should watch out for: 
  • Property taxes – This is a straight up annual tax based on the value of the property. In England the going tax rate is 2.53%. 
  • Transfer taxes – Many countries impose a transfer fee at the time of purchase. In Belgium the transfer fee is a whopping 11.3%. 
  • Capital gains tax – When it comes time to sell the international property, how much will the host country tax the sale? In Denmark you could be looking at a 42% tax bill. 
  1. Work with local professionals 
    Let’s face it. As much as you may love foreign travel, you’re most probably not a real estate expert in the country that you’re considering. That means if you want your Self Directed IRA to have a profitable international experience, you have to find trustworthy local professionals who can make the deal happen. The real estate situation is many foreign countries is not as democratic as it is in the United States. It is not uncommon in some locales for natives to be quoted one price, while foreigner with fat wallets get quoted a very different price. Finding a trustworthy agent who can both source and broker the property for you is essential to getting a decent price. 

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