The Right IRA for Buying Investment Property in MEXICO

THE RIGHT IRA FOR BUYING INVESTMENT PROPERTY IN MEXICO

A GUIDE FOR U.S. CITIZENS A N D R E A LT O R S

THE RIGHT IRA FOR BUYING INVESTMENT PROPERTY IN MEXICO

Opportunities exist for account holders to utilize retirement account funds for alternative investments. It is estimated that there are approximately $7.6 trillion invested in IRA accounts. Roughly 47% of the funds are held in mutual funds while the amount held in alternative assets such as foreign real estate is thought to be less than 2% of all IRA assets.

KEY TAKEAWAYS

•

You can hold real estate in your IRA, but you’ll need a self-direct-

ed IRA to do so.

•

Any real estate property you buy must be strictly for investment

purposes; you and family members can’t use it.

•

Purchasing real estate within an IRA usually requires paying in

cash, and all ownership expenses must be paid by the IRA. •

Holding real estate in your IRA can be tricky, with tax issues and

red tape. But, on the other hand, property can provide you with a good (or great) rate of return, and diversify your portfolio.

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IRAS ACCESSIBLE TO ALL

Since the IRA was established in 1974, investing in alternative assets has been permitted by the IRS. Despite this fact, few Americans realize that they can use their self-directed IRAs to invest in assets other than stocks, bonds, and CDs. This misapprehension can be attributed to the fact that few brokers and advisors know how to invest in alternative assets. They also do not want to lose their clients by having them auto-invest their pension funds. By taking control of their pension funds through self-directed IRA accounts, Americans can increase returns on their investments by making the right choices and reduce fees and administrative costs payable to brokers and advisors.

American Citizens can increase returns on their pension savings, thereby securing their retirement, by purchasing Mexican real estate with a self-directed IRA (Individual Retirement Account). They will also be preparing for a better quality of life during their retirement. It is a well-known fact that Mexico is in the top five countries to retire in. This guide will assist Americans and their realtors in investing in Mexican real estate using their IRAs.

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THE RIGHT IRA FOR BUYING INVESTMENT PROPERTY

First of all, your IRA has to be self-directed. The term “self-directed” means that alternative investments are accepted or offered by the IRA custodian, the financial institution or company responsible for record-keeping and IRS reporting requirements. A self-directed IRA is independent of any brokerage, bank, or investment company that would make decisions for you (most brokerage accounts don’t allow real estate holdings, anyway).

To buy and own property via your IRA you will still need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these types of real estate transactions.

As you would expect, the custodian will charge a fee for the service.

However, it won’t advise you on how to best structure your holdings.

This custodian’s job is to handle the back-office work. Before we look at the rest of the rules, understand this basic fact: You and your IRA are two separate entities. Your IRA owns the property—you don’t. In fact, the title to the property will read “XYZ Trust Company Custodian [for benefit of] (FBO) [Your Name] IRA.”

If you buy real estate with your IRA improperly, you can disqualify the IRA. If that happens, all the funds in it immediately become taxable.

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KNOW THE RULES BEFORE YOU START

Investing in alternative assets has been permitted by the IRS since 1974. The IRS references the lists of investments that are prohibited in IRAs. Therefore, anything that is not prohibited is permissible if the IRS rules governing retirement plans are also respected. Assets that are not permitted in an IRA are: artwork, rugs, antiques, gems, stamps, coins, alcoholic beverages, life insurance policies, and certain precious metals. The reason that they are not permitted is that they are difficult to accurately appraise the value of these items, and their possession and ownership is difficult to ascertain. Who is the legitimate owner of an expensive, rare bottle of champagne? What is it worth? Other than these prohibited items, all other types of assets, including foreign real estate, is permitted.

Eligible self-directed account types In addition to traditional and Roth IRAs, any self-directed account can be used to make alternative investments. However, for the reasons explained later, only a self-directed IRA LLC will enable you to acquire Mexican real estate.

Self-directed IRA Limitations To ensure that you continue to invest your self-directed retirement account within the limitations described by the IRS, it is essential that you are aware of the following rules before you make your acquisition.

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ARM’S-LENGTH INVESTING

IRS rules state that you cannot directly benefit from an asset owned by your IRA. Keep in mind that the IRA was created to provide for your retirement and not intended for you to benefit and enjoy the property now. Therefore, it is strictly prohibited for you to engage in transactions that, directly or indirectly, will benefit you. Here are some examples of transactions that are strictly prohibited: using the real estate purchased through your IRA for personal use, vacation home, retirement, or as an office. You cannot occupy or rent it to yourself. It must be rented to others, and your IRA can sell it at any time. You cannot lend yourself money from your IRA nor can you pay yourself a salary or fees for managing the property.

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WHAT IS AND ISN’T YOURS Your real estate property must be purely an investment. You can’t use it as a vacation home, a place for your kids to live, a second home, or an office for your business. These rules apply to you and to people the IRS deems “disqualified.”1 So who is considered a disqualified person?

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Your spouse

•

Your parents, grandparents, and great-grandparents

•

Your children and their spouses, grandchildren, and

great-grandchildren •

Service providers of your IRA

•

Any entity that owns more than 50% of the property

You also can’t purchase the property from one of these disqualified people—this is called a self-dealing transaction—nor can the IRA purchase property that you already own.2 You can learn more about prohibited transactions in section 4.72.11.2.1 of the Internal Revenue Manual.3

DISQUALIFIED INDIVIDUALS

The IRS code stipulates that your IRA cannot buy an investment from, sell to, or otherwise be involved with any disqualified person. A disqualified person includes the account holder, your spouse and your ascendants and descendants. This means parents, grandparents and great-grandparents, children and their spouses, grandchildren, great-grandchildren and their spouses are also covered by the prohibition. This also includes individuals that provide services to the IRA such as your custodian, your attorney, CPA and financial advisor.

Surprisingly, the law does not specifically include brothers and sisters as disqualified individuals. Therefore, it is feasible for them to occupy the property and even manage it for you.

PENALTIES

The IRS takes the dealing of disqualified individuals with the IRA seriously. If you participate in a prohibited transaction as described above, your IRA will be de-registered, and it will be treated as though the property was distributed and you will have to pay the tax on that distribution. If the IRS considers this a distribution, it can also impose a tax equal to 100% of the amount involved.

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RAISING CAPITAL

It may be necessary for you to raise capital to make this purchase, as your IRA account may be insufficient. Even though you are a disqualified person, you can use your finances and buy the property with your IRA as a partner, but you cannot lend to it. There are several other ways of doing this. The first would be to buy the property with other individuals as partners. These individuals can use their own IRA accounts, in which case they must follow the same process as described below, or invest directly by using their own, non-pension funds. Profits generated by the property will be shared according to each owner’s vested interests. The second way would be to get friends or members of your family to invest in your Mexican LLC, as shareholders, in which case they would receive dividend payments, or as a loan with a guaranteed return in the form of interest payments. Finally, your American LLC. self-directed IRA can borrow the money required to purchase the property under specific conditions.

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BORROWING MONEY

Property owners know that cash flow is an important consideration for property repairs and renovations. As your IRA contributions are limited to $5000 per year or $6000 if you are over the age of 50, you will need to pay for these expenses by using liquidity in your IRA. It would be prudent to set aside reserves from operating income within your IRA or obtain the required liquidity elsewhere. As mentioned earlier, you cannot lend money to your IRA personally. The same applies to other disqualified individuals as defined above. Therefore, your IRA will have to borrow the money, not you. The IRS code provides that the IRA can only borrow money from a non-disqualified individual or entity on a nonrecourse basis. This means that if the IRA is in default of the loan conditions, the lender can only have recourse against the IRA to collect. Only the property held within the IRA can serve as collateral for the loan, and you cannot provide any other property as security. Nor can you personally endorse the loan.

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FIVE STEPS TO ACQUIRE MEXICAN REAL ESTATE

STEP 1- IRA LLC Before investing in Mexican real estate or identifying your investment using your IRA, it is recommended that you prepare for the process in the U.S. first. If you haven’t already done so, you should rollover or transfer any existing 401(k) or other private pension fund vehicle into a self-directed IRA LLC. For the reasons mentioned below, an American LLC will be required for this investment.

Not all private pension fund managers or custodians are familiar with investing in foreign real estate using an IRA. Before you proceed further, confirm with your custodian that they are familiar with the process and are willing to accompany you through it. If not, change custodians.

In chronological order, you should: •

Create an American LLC with the wording in its Operating

Agreement required for this type of investment. You will need to consult an attorney for this as few pension fund managers and custodians will participate in the creation of your LLC; •

Appoint your pension fund manager as custodian for this invest-

ment. They will surely provide you with numerous forms to complete this process; •

Open a bank account for your LLC;

•

Transfer your existing pension fund money to your new bank

account.

Other than the creation of your LLC, it can take between five to seven business days to transfer your existing pension funds to your new self-directed IRA.

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STEP 2 – CHOOSE YOUR PROPERTY

This is the fun part, choosing your Mexican property. If you are using the services of a local realtor, inform them of the fact that you will be acquiring your property using your IRA and that the process will be slightly different from what they are familiar with. They should know that: (1) you will be making an offer “on behalf of a Mexican legal entity to be formed and not personally”; (2) the deposit will come from your IRA LLC in the U.S. The balance of the funds for the acquisition at the closing can come from the Mexican corporation or an escrow account.

(3) Inform your realtor of the IRS limitations prohibiting you or members of your family from using the property. Ask them to identify opportunities that guarantee a return on your investment, or a property manager that can offer you similar assurances. This way your realtor will know what properties to focus on and will not waste your time.

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STEP 3 – MEXICAN LLC

The Mexican Constitution prohibits foreigners from purchasing property within 50 km (31 miles) from the shore, or 100 km (62 miles) from any border. Since 1973, foreigners have been able to purchase property within this restricted zone by purchasing through a bank trust (Fideicomiso) or a Mexican LLC. If you are using your self-directed IRA to purchase property within this restricted zone, you cannot use a bank trust to do this as your custodian would have to be the beneficiary of the trust and not you personally. Custodians, which are usually large corporations with numerous shareholders and complex statutory compliance requirements, will not accept to act as your beneficiary of the trust as the process is complicated, prolonged and time-consuming. For the same reasons, they will also not act as the shareholder or representative of your Mexican LLC. Therefore, the only practical way to purchase Mexican real estate using a self-directed IRA is to do so through an American LLC, as a shareholder of a Mexican LLC.

The process of creating a Mexican LLC is relatively simple. However, you should verify that your Mexican lawyer has previous experience in creating one that will be used for the specific purpose of investing your IRA funds. In general, the process is:(1) the incorporation certificate of your American LLC must be notarized by a Notary Public in the U.S. and “Apostilled” by the U.S. Secretary of State in your area; (2) the Board of Directors must appoint you as the legal representative of the American LLC to create the Mexican LLC, and act as its director and (3) you must provide information on the head office and the names and address of the directors of your American LLC.

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These documents must be translated into Spanish in Mexico before your Mexican lawyer can proceed to create your Mexican LLC. Finally, remember that the operating agreement for the Mexican LLC must also provide the specific language required by the IRS specifying that disqualified individuals cannot use or occupy the property.

STEP 4 – CLOSING

By now, you have created and registered an American LLC as your self-directed IRA, appointed a custodian, opened a bank account for your American LLC, selected your property in Mexico with an accepted offer and created a Mexican LLC in which your American LLC is a shareholder. You are now ready for the closing or the titling of the property.

The balance of the funds can come from your Mexican LLC. A bank account should be open for your Mexican LLC, and the funds should be transferred from your American LLC bank account. To expedite the process and avoid having to open a local bank account, consideration should be given to using escrow services. The funds can come from the escrow account on the condition that the beneficiary of the account is identified as the Mexican LLC.

At the closing, you will be signing as the official representative of the Mexican LLC and take possession of the property on its behalf.

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STEP 5 – MANAGE THE INVESTMENT

Once your IRA owns your Mexican property, all expenses and profits related to the investment must come from and return to the IRA account. Your custodian and occasionally the IRS will need to see proper accounting and the traceability of transactions. At this point, you can have two bank accounts open. One in the U.S. for your American LLC and one in Mexico for your Mexican LLC.

Regardless of which account you use to operate, it is advisable to keep all transactions in the same account. In other words, income and expenses should be reflected in only one of the two accounts. Occasionally, profits (in the form of dividends) may be directed from the Mexican account to the U.S. account.

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MAKING THE PURCHASE

Your IRA balance will have to be pretty high because getting a mortgage to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which not only takes a big bite out of the account, it also affects your rate of return down the road.

Real estate investors often put down a small amount and take advantage of still relatively low-interest rates to leverage the purchase, figuring they can make more money on the property than they’ll pay in interest. If you can’t finance your real estate purchase, you lose that potential for a significant return on investment (ROI).

Some banks will consider loans for this sort of transaction, but it presents another problem: Any revenue from the property may then be considered unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).4

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OWNING THE PROPERTY

As your IRA doesn’t pay taxes, you can’t take advantage of the deductions that come with owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation. If your property generates rental income, every bit of it goes right back into your IRA. As you don’t own the property, you can’t pocket any of the income. (Of course, you will get the money eventually, when you make withdrawals from the account at retirement.)

On the bright side, none of the maintenance or other associated costs of owning real estate comes out of your pocket. The IRA pays for everything. However, this is not without drawbacks. Every dollar that comes out of your IRA is a dollar that no longer gets a couple of decades to appreciate in value tax-free.

One huge risk: maintenance expenses that drain your IRA’s cash and lead to expensive penalties if you “over contribute” to the account to cover them.

And what happens if property incurs a series of major expenses that push your IRA balance so low that the account doesn’t have enough money to pay for it? Remember, you can’t pay for anything relating to this property out of your own pocket, and IRA contributions are limited: You can only deposit $6,000 in 2020, $7,000 if you’re 50 or older.5

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OWNING THE PROPERTY

If that doesn’t cover the repair, and you have to deposit more, you’re on the hook for penalties associated with contributing too much. This is a significant risk, as property can quite often require pricey upkeep, and the income you get from rentals may not cover what you need to spend in a high-maintenance year.

You can purchase with your IRA if it is strictly income producing property and no personal use (no leeway on this), and if it is in the interior of Mexico where no fideicomiso/bank trust is required for foreign nationals to purchase property in Mexico. The problem of purchasing using a self-directed IRA is when a fideicomiso is required. By Mexican law, all foreign nationals purchasing in the restricted zone in Mexico require a fideicomiso. The restricted zone is 100 kilometers from the Mexico border, and 50 kilometers from the ocean. This means that a foreign national (i.e. US and Canadian citizens) needs a fideicomiso/ bank trust unless they purchase in the interior of Mexico – areas like Lake Chapala/Ajijic, San Miguel de Allende etc. All lenders who are doing loans in Mexico require a fideicomiso EVERYWHERE in Mexico.

This is a lender requirement, not a Mexico government requirement.

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OWNING THE PROPERTY

To purchase real estate property through your self-directed IRA, the property must be in the name of the LLC that is set up. When purchasing with a loan in Mexico, title MUST be taken in individual names.

Taking title in an LLC name is not allowed. Therefore, it is not possible to use a loan AND your self-directed IRA.

Additionally, all USDollar residential mortgage lenders in Mexico will not do loans on investment property – loans can be done only for vacation/second homes. People may choose to rent out their homes in the future, but again, this is personal use/rental of your property would be at cross-purpose with the requirements of the IRA purchase. With the self-directed IRA, the property MUST be an income producing property and zero personal use (not even one day) is allowed. The IRS is monitoring this very closely for self-directed IRA’s.

•

Bottom line, there is no way to purchase a property in Mexico

with both your IRA AND a mortgage loan in the restricted zone of Mexico (which is where most US and Canadian citizens choose to purchase).

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SELLING THE PROPERTY IN AN IRA

To sell your property, work out a sales price just as you would with any other real estate holding. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA either tax-deferred or taxfree, depending on the makeup of your IRA.

One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money along the way. As eight million people learned in the Great Recession of 2008, you could find yourself with an asset that is worth less than the amount of money you owe on it.

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PROS AND CONS OF PROPERTY IN AN IRA

We’ve mentioned so many hassles and drawbacks, you might be wondering at this point if there is any point to putting property in an IRA. Historically, real estate has been a good long-term investment as property values rise over time, and long-term appreciation goes hand-inhand with the long-term investment horizon of a retirement account.

In the short term, any income the property generates is tax-sheltered within the IRA. Finally, as a hard asset, real estate helps diversify a portfolio otherwise invested in equities and other securities—not the worst idea in the world.

Pros •

Real estate helps diversify a portfolio, often moving counter to

financial markets.

•

Real estate has historically appreciated over time, ideal for an

IRA’s long-term investment horizon.

•

Real estate can provide a steady income stream from rents, and

any rental income you collect grows tax-free within the IRA. •

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You can buy, sell, flip, and accumulate properties.

PROS AND CONS OF PROPERTY IN AN IRA

Cons •

You need to set up a self-directed IRA with a custodian.

•

You can’t claim deductions for property taxes, mortgage inter-

est, depreciation, and other property-related expenses.

•

All expenses, repairs, and maintenance costs must be paid with

IRA funds, and you must pay others to do them and manage the property.

•

You and your relatives can’t live in or run a business out of the

property.

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THE BOTTOM LINE

Using an IRA to buy an investment property is not for the faint of heart, nor is it for anyone unfamiliar with the differing types of individual retirement accounts. Real estate investing of any type is quite risky or at best high maintenance; for an IRA, though, real estate is a particularly high-risk choice. Not only may property values drop rather than rise, a year of significant maintenance costs could also subject you to penalties if your income and IRA contribution limit don’t cover repairs you can’t afford to ignore.

Unless you have both the time and expertise to manage real property, you are probably best off with more mainstream strategies for your IRA. Or consider securitized real estate options, like real estate investment trusts (REITs) or mutual funds and ETFs that invest in property.

These are an indirect form of property ownership, but they’re a simpler, more liquid proposition—and they can be held in regular IRAs, too.

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