I think you go right into SMF with an engine swap. You definetely can be competitive, I built a 1.8t in the past to be regionally competitive in SM a few years ago, and you're starting over 500 lbs lighter.
You'll definetely need to think about a limited slip and fitting a 275/35/15 Hoosier onto the vehicle.
Look at my old post--"my VW with 15x10's and 275's"
If you are serious about competing, you really should read the rule book related to things you can and can't do in your class. The rules can be somewhat difficult to grasp for some but always use the rule of thumb... "unless the rules say you can, then you can't".
At a local level, things are typically pretty laid back, but regional and national competitions could be a different story if you overstep the limitations of the rules.
I think a 1.8t could be a good power plant in a MK2. Just make sure you size the turbo appropriately to eliminate all turbo lag and focus on torque not hp. Given the choice between more hp or torque, I'll take the extra torque every time.
There is a lot you can do with a SMF car. Here are some highlights,,, engine swaps (must be from same manufacturer), forced induction, intercoolers, ecu or stand alone, lots of suspension goodies like coilovers, offset bushings, any sized roll bars, all types of bracing, race seat, swap steering wheel, any wheel/tire size, big brakes, any battery (can relocate it), min weight will be under 2,000 lbs for a 1.8 with forced induction. You aren't allowed to gut the car (I believe you can remove the rear seat), gotta keep bumpers, cant modify suspension attachment location points, cant remove the rear beam and go indi rear suspension, The list goes on.
Here is the deal though and I speak for personal experience: I'm not convinced that a VW is the car to have in SMF so if your aspirations are a win at nationals, you may want to start with a different car but if you want a killer SMF car I'd say you are on the right track.