Mitigating U.S. Income Taxes
An increasing number of Americans have been expatriating from the United States and surrendering their US passports due to high income tax rates. While it generally makes sense from a U.S. federal income tax perspective for high income U.S. taxpayers to consider expatriating from the United States, many people don’t want to give up their citizenships or green cards simply to reduce their federal income tax liabilities. Additionally, expatriating U.S. citizens are subject to certain immediate tax consequences as a result of the expatriation tax regime under Internal Revenue Code Section 877A.
Puerto Rico offers a compelling alternative to expatriation. U.S. citizens who become bona fide residents of Puerto Rico can maintain their U.S. citizenship, avoid U.S. federal income tax on capital gains, including U.S. source capital gains, and avoid paying any income tax on interest and dividends from Puerto Rican sources.
Puerto Rico – A U.S. Commonwealth
Puerto Rico is a U.S. commonwealth, which means that it’s an unincorporated territory of the United States. Individuals who are born in Puerto Rico are considered U.S. citizens. Puerto Ricans elect their own governor (although they do not have representation in the U.S. Congress). Puerto Rico is subject to U.S. federal laws unless specifically exempted. Puerto Rican banks are regulated by the U.S. Federal Deposit Insurance Corporation, and the Commonwealth’s currency is the U.S. dollar. No passport is required for U.S. citizens to travel to Puerto Rico.
Income Taxation Basics
As a general rule, a U.S. citizen or resident is subject to federal income taxes on his worldwide income, regardless of domicile. However, Puerto Rican residents are exempt from this rule. Under Internal Revenue Code (IRC) Section 933, bona fide residents of Puerto Rico who have income sourced to Puerto Rico are exempt from U.S. federal income taxation. IRC Section 937 defines a “bona fide” resident as a person who: (1) is present in Puerto Rico for at least 183 days during the taxable year; (2) doesn’t have a tax home outside Puerto Rico; and (3) doesn’t have a closer connection to the United States or a foreign country than to Puerto Rico.
A Puerto Rican entity isn’t subject to U.S. federal income taxation unless the entity is engaged in a trade or business within the United States and its income is considered effectively connected income or it derives investment income that would be subject to a withholding tax under the IRC.
In sum, bona fide residents of Puerto Rico and entities that aren’t organized in the United States aren’t subject to U.S. income tax on Puerto Rico source income.
Moving to Puerto Rico
On Jan. 17, 2012, Puerto Rico passed a significant law designed to generate economic activity on the island. The Act to Promote the Relocation of Individual Investors to Puerto Rico (the Investor Act), was enacted to incentivize investors to become residents of Puerto Rico by exempting from Puerto Rico income taxation income from interest, dividends and capital gains realized or accrued after such investors became bona fide residents of Puerto Rico.
The Investor Act
To qualify for the income tax exemption, an individual must become a bona fide resident of Puerto Rico on or before the taxable year ending on December 31, 2035, and may not have been a resident of Puerto Rico at any time during the 6 years prior to the enactment of the Investor Act (January 17, 2012).
The Investor Act defines the term “bona fide resident” as a person who is domiciled in Puerto Rico. An individual is presumed to be domiciled in Puerto Rico if the individual is present in Puerto Rico for a period of 183 days during the calendar year. Part of the qualification process requires the taxpayer to apply for a tax exemption decree with the Puerto Rican government. The effective period for tax exemption generally begins on the date the individual becomes a bona fide resident of Puerto Rico and ends on Dec. 31, 2035.
Under the Investor Act, an individual who hasn’t been a resident of Puerto Rico for the 6 years prior to effective date of taking residence in Puerto Rico is entitled to a special long term capital gains rate until Dec. 31, 2035. If the gain accrued before the individual investor became a Puerto Rico resident, the tax rate depends on when such gains are recognized. If the gains are recognized within 10 years after the date the individual establishes residence in Puerto Rico, the gains will be taxed at a 10 percent rate. If the gains are recognized after the 10-year period and prior to Jan. 1, 2036, they’re subject to a 5 percent rate.
U.S. residents moving to Puerto Rico will be subject to federal income taxes on any gains accrued prior to becoming a bona-fide resident of Puerto Rico, but can credit any Puerto Rico income taxes paid. Any long-term capital gains from appreciated assets accrued after the investor becomes a Puerto Rican resident will be exempt from U.S. federal and Puerto Rico income taxes. The taxpayer should be prepared with appraisalsand records to establish the values of appreciated assets as of the date that he established Puerto Rican residence.
Furthermore, until Jan. 1, 2036, interest and dividends that are Puerto Rico source income are wholly exempt from Puerto Rico income taxes, as well as from federal income taxes.
Who Should Consider Moving?
High-net-worth individuals with significant capital gains from stocks and securities and expected future passive income may benefit the most from relocating to Puerto Rico. Cryptocurrency holders may find it advantageous to relocate to Puerto Rico as well. With the combination of the Puerto Rico income tax exemption provided by the Investor Act, the 20 percent capital gains rate and the imposition of the 3.8 percent Medicare tax on net investment income, certain U.S. citizens will find that Puerto Rico is a viable tax haven.
An individual’s real domicile must be in Puerto Rico. The taxpayer must make a permanent move to Puerto Rico, and his/her actions must reflect the change in domicile. Strongly recommended actions include selling the primary residence outside of Puerto Rico, moving his/her immediate family and becoming a member of local religious, cultural and social institutions. Additionally, the taxpayer should purchase a residence that supports a permanent move to Puerto Rico and register to vote in Puerto Rico, spend minimal time in the United States and otherwise sever ties with his/her original home state.. The taxpayer could also have a problem if his/her livelihood is based on the United States, as he/she will run afoul of the “tax home” rules even if he/she spends the majority of his time in Puerto Rico. The taxpayer should keep a diary of days spent in Puerto Rico, as this information will certainly come up in audit. The IRS doesn’t take kindly to tax avoidance and may request back taxes, penalties and interest if it’s successful in a residency audit.
The individual States have their own residency rules which may differ from the federal rules, and the taxpayer should take these rules into account for state taxation purposes.
It should be noted that relocating to Puerto Rico doesn’t absolve a U.S. citizen’s obligations with respect to FATCA, including reporting obligations. For taxpayers seeking to avoid the draconian FATCA implications who may not be eligible for the voluntary disclosure programs, expatriation may be the best option.
High net-worth individuals should speak with an advisor to see if moving to Puerto Rico would be a viable option to mitigate substantial tax consequences.
Should you have any questions or desire further insight, feel free to contact one of the members of our Tax Department:
DISCLAIMER: This article is not intended to provide legal advice, and no legal or business decision should be made based on its contents.