Have you moved outside the US and found the perfect addition to your investment portfolio? Or do you simply want to obtain offshore asset protection benefits for your retirement savings? You can accomplish these goals by investing through an Individual Retirement Account (“IRA”) that’s set up as an “offshore IRA.”
This article builds the structure up step-by-step, discussing the investment structure itself and the US tax issues.
Self-Directed IRA Basics
As the name indicates, the chief advantage of a self-directed IRA is investment choice-you (and not your IRA custodian) gets to choose the assets in which you invest. A self-directed IRA can generally invest in absolutely anything except for life insurance and collectibles. On the other hand, the standard sort of institutional IRA custodian only offers a limited menu of publicly traded stocks, bonds, and mutual funds.
The first step in forming a self-directed IRA is rather obvious-you need to have your retirement assets in an IRA. If you’ve already been saving through an IRA while working, then you’re already there.
However, if you’ve been saving through a 401(k) or similar plan, you would need to use a “tax-free rollover” to move the assets to an IRA. A rollover is generally only possible after certain life events, such as a separation of service from the employer that maintained the 401(k).
Turning a Self-Directed IRA into an Offshore IRA
The first step is to move your IRA from the standard sort of IRA custodian to a self-directed IRA custodian (i.e., a custodian that allows you to make alternative investments, such as non-US real estate). Once you move your IRA to the new custodian, you can simply direct the custodian to purchase non-US real estate.
However, if you were to stop here, you’d have to get the custodian involved any time you wanted to do something with your IRA. The custodian would need to sign all documents with respect to the investment and disburse all funds to purchase and maintain the investment, services for which they are likely to charge a fee.
So, for these reasons, it’s much better to hold investments through a company underneath your IRA. So, your IRA’s only direct investment is the interests in the company. This structure is sometimes referred to as a “checkbook IRA” because your role as manager of the copmpany gives you “checkbook control” over funds in the IRA. Additionally, if you don’t have all of your IRA funds in the new investment, the company insulates your IRA’s other assets from any potential liabilities associated with the new investment.
Finally, the company through which the IRA invests could be formed under the laws of a non-US jurisdiction (such as Belize, BVI, Nevis, etc.). This structure provides the additional asset protection benefits of moving your assets more fully outside US jurisdiction. It also allows your IRA to avoid realizing “unrelated business taxable income” (“UBTI”), which is taxable income to the IRA. This structure is often referred to as an “offshore IRA”.
Beware of “Prohibited Transactions”
Of course, all of this freedom comes at a price: an offshore IRA has quite a bit of tax complexity.
One area of complexity is the “prohibited transaction” rules. Broadly speaking, your IRA (or company below your IRA) cannot engage in any business with a “disqualified person” (which generally includes you, your family, and your business associates).
Some implications of these rules are as follows:
- all funds that go into the investment must come from the IRA or a third party (i.e., your IRA generally cannot invest alongside a disqualified person);
- your investment must be managed and maintained by a third party (i.e., neither you nor a disqualified person can perform work on the property or market it for sale or rental); and
- no disqualified person can use the property for any personal purpose (including living in it or even staying for one night).
Structuring Borrowing under your IRA
Borrowing by your self-directed IRA to fund investments raises another set of complexities.
First, the loan must be wholly nonrecourse—the lender cannot be able to reach the IRA, any IRA asset, or any disqualified person to repay the loan. The loan documents and applicable law must be closely scrutinized to insure that the above requirements are met.
Second, the loan must be properly structured so that it does not cause the IRA to pay US income tax with respect to a portion of its income. When an IRA borrows to purchase an asset, current income from the asset and gain on the sale of the asset are treated as UBTI to the extent of the debt-financing. So, for example, if an IRA purchases property with $20 of its own cash and $80 of debt, then 80% of the current income and gain from the property would be UBTI.
These issues can often be structured around with proper up-front planning.
Local Country Issues
Finally, all of the above complexity occurs before we even consider local country requirements. For example, you may need to hold the property through a company or other legal structure formed in the jurisdiction where the real property is located. This may be necessary to avoid restrictions on foreigners owning certain types or amounts of property. Or, it may be beneficial to hold the property through a company formed in a different jurisdiction to avoid transfer tax on its eventual sale.
Each of these issues must be weaved into the structure along with all of the other issues described above. The self-directed IRA is definitely not a one-size-fits-all proposition.
Not a DIY Project
An offshore IRA provides great tax benefits and asset protection opportunities. However, due to its inherent complexity, this structure should only be formed with the help of a qualified US tax attorney.
Unfortunately, many people in the offshore investment community treat this structure as simply another item to sell to customers. I do things differently. I don’t have customers; I have clients.
For my offshore IRA clients, I provide a full set of services that allows you to use your structure with confidence. Get in touch and we can discuss your plans and how I can help.
Want to know more? The Tax-Savvy Expat courses teach you everything you need to know about expat tax.