Puerto Rico residents: Scope of income tax exemption for capital gains

Editor: Mo Bell-Jacobs, J.D.

The tax advantages available in Puerto Rico have recently captured the interest of both taxpayers and the IRS. The widespread adoption of remote work in many industries such as finance, law, and marketing has enabled many professionals and businesses to move their residency and operations to Puerto Rico.

The island has attracted many U.S. persons with its warmer climate and favorable tax regime. For example, a Puerto Rican investment incentive law passed in 2012, the Individual Investors Act (Act 22, now Chapter 2 of Act 60), exempts from taxation all passive income, such as interest, dividends, and capital gains, realized or accrued after an individual becomes a bona fide resident of Puerto Rico. Furthermore, the prospect of higher U.S. federal and state income taxes prompts many taxpayers to flee to lower-tax jurisdictions. Puerto Rico residency offers some U.S. citizens and residents the ability to exit, to some extent, the U.S. income tax system without renouncing citizenship or becoming subject to the exit tax regime under Sec. 877A.

The profiles of taxpayers moving their homes and businesses to Puerto Rico include cryptoasset and other investors, attorneys, investment fund managers, and other business owners. Recent press has shed light on the extraordinary tax benefits enjoyed by some residents of Puerto Rico, adding allure to the tactic. The growing number of U.S. persons that have moved to Puerto Rico has also caught the attention of the IRS, which announced a formal campaign focusing on U.S. individuals who have wrongfully claimed U.S. and Puerto Rican tax benefits (see IRS, Large Business and International Active Campaigns, Puerto Rico Act 22, Individual Investors Act (Dec. 9, 2021)).

A person must meet extensive rules and requirements to qualify for the favorable tax treatment available to residents of Puerto Rico. Not least among them are the high thresholds to qualify as a bona fide resident; however, these requirements are beyond the scope of this item. Instead, the following discussion focuses on the type of income eligible for the U.S. income tax exemption for U.S. taxpayers that establish bona fide residence in Puerto Rico. The taxation of preemigration gains is of particular importance to U.S. taxpayers who own significant appreciated assets. Generally, while U.S. taxpayers can greatly reduce the tax burden on the growth of their businesses and investments occurring while they reside in Puerto Rico, preemigration growth and appreciation are in many cases subject to U.S. income taxation, even if the gain is recognized after establishing bona fide residence in Puerto Rico.

US exemption from income tax for certain residents of Puerto Rico

Under Sec. 876, bona fide residents of Puerto Rico are not subject to the rules typically applicable to nonresident aliens under Secs. 871—879. Rather, Puerto Rico residents are subject to the same worldwide income tax at graduated rates imposed by Sec. 1 that applies to U.S. citizens and residents. However, Sec. 933(1) provides an important exemption from U.S. income tax for certain Puerto Rico residents on their income derived from Puerto Rican sources. It should be noted that this is not a blanket exemption but only covers Puerto Rican—source income. In effect, for bona fide residents of Puerto Rico, only Puerto Rican income tax applies to such income.

Income derived from sources in Puerto Rico with respect to capital gains

Secs. 861-865 provide the rules for classifying income from sources within Puerto Rico (Sec. 937(b)(1)). Generally, under Sec. 865(a), income from the sale of personal property is sourced to the country of residence. This rule covers the disposition of investments and other capital investments but not real estate or inventory sold in the course of business. A U.S. citizen or resident will not be treated as a U.S. resident for purposes of sourcing gains under Sec. 865 if he or she has a tax home in a foreign country. Any possession outside the United States, including Puerto Rico, qualifies as a foreign country for purposes of the Sec. 865 sourcing rule (Sec. 865(i)(3)). Therefore, if a U.S. citizen who is a bona fide resident of Puerto Rico sold stock or similar property at a gain, the gain would generally be Puerto Rican-source income not subject to income tax in the United States, pursuant to the exclusion in Sec. 933.

However, in an exception to this general rule, Sec. 865(g)(2) provides that a U.S. citizen or resident shall not be treated as a nonresident with respect to any sale of personal property unless an income tax equal to at least 10% of the gain derived from such sale is actually paid to the foreign jurisdiction. This rule would seem to frustrate the purposes of Puerto Rico’s incentive programs.

However, there are two exceptions to the 10% tax rule in Sec. 865(g)(2). First, Sec. 865(g)(3) provides that the rule does not apply to the sale of stock in a corporation that is engaged in an active trade or business in Puerto Rico and that earns most of its gross income from activities in Puerto Rico.

Second, Sec. 865(j)(3) authorizes Treasury to prescribe regulations that waive the 10% tax rule of Sec. 865(g)(2) for purposes of the Sec. 933 exclusion. With this authorization, the gain from the sale of certain property by Puerto Rican residents could be exempt under Sec. 933 even if the gain was subject to very low income taxation under Puerto Rico’s incentive programs. Although this provision was enacted in 1988, Treasury has not issued regulations. However, the Service did publish Notice 89-40, which announced that regulations would provide that the 10% tax payment rule of Sec. 865(g)(2) does not apply to bona fide residents of Puerto Rico for the entire tax year.

Sec. 865(j)(3) specifically provides that the regulations may include provisions comparable to the old expatriation rules under Sec. 877 to prevent U.S. citizens who are only temporarily residents of Puerto Rico from escaping income tax on the sale of assets. However, regulations finalized in 2008 under Sec. 937(b), described in the following section, likely address the issue of U.S. persons moving to Puerto Rico to avoid taxes on assets prior to becoming residents of Puerto Rico.

Special sourcing rule for property owned before residency in Puerto Rico

U.S. citizens and residents who move to Puerto Rico are subject to a second sourcing rule that causes the gain on assets owned at the time of the move to be subject to U.S. taxation and not eligible for the exclusion under Sec. 933. This rule curtails the ability of U.S. taxpayers with appreciated assets to avoid U.S. income tax on the growth by establishing residence in Puerto Rico. Regs. Sec. 1.937-2(f) provides the general rule that income from Puerto Rican sources does not include the gain on the sale of investment property (such as stocks, bonds, and other passive-income-generating assets) that was owned before the taxpayer became a bona fide resident of Puerto Rico and where the taxpayer was a U.S. citizen or resident and not a bona fide resident of Puerto Rico during any of the 10 years preceding the year of the sale. Since such gain would not be income from sources within Puerto Rico, the Sec. 933 exclusion does not apply. Therefore, in many cases, a U.S. citizen or resident cannot avoid U.S. income taxation on gains associated with appreciation in investment assets by establishing bona fide residence in Puerto Rico unless recognized after 10 years of bona fide residence in Puerto Rico. The Puerto Rican tax incentives and the exemption from U.S. taxes generally apply to income and appreciation occurring after establishing residence in Puerto Rico.

The regulations do enable taxpayers to exclude some portion of taxable gain attributable to appreciation occurring during their residence in Puerto Rico (Regs. Sec. 1.937-2(f)). These provisions permit two approaches to sourcing the gains between Puerto Rico and the United States depending on the type of asset: one for marketable securities and one for property other than marketable securities (Regs. Secs. 1.937-2(f)(1)(vi)(A) and (B)).

Marketable securities: For marketable securities, the taxpayer may treat a portion of the gain sourced to Puerto Rico by reference to the market value of the property at the close of the market on the first day the taxpayer becomes a bona fide resident of Puerto Rico (see Regs. Sec. 1.937-2(f)(1)(vi)(A)). For purposes of this rule, “marketable securities” means property that is actively traded on an established financial market within the meaning of Regs. Sec. 1.1092(d)-1(a).

Example: A private-equity manager who is a U.S. citizen resident in the United States owns an interest in the stock of Company A, which was acquired in 2015 for $100. In 2020, the manager moved to Puerto Rico and established bona fide residence. Company A is publicly traded on a national exchange. On the first day of the manager’s bona fide residence in Puerto Rico, his interest in the Company A stock had a market value at the close of the market of $500. In 2022, the manager’s interest is sold for $1,000. Under the general rule in Regs. Sec. 1.937-2(f), the entire $900 gain would be U.S.-source income and not exempt from U.S. income taxation under Sec. 933, since the manager owned the interest before becoming a bona fide resident of Puerto Rico and is a citizen of the United States. However, the manager may elect to treat the $500 of gain occurring after establishing bona fide residence in Puerto Rico as income from sources within Puerto Rico. The remaining $400 of gain is U.S.-source income that is ineligible for the exclusion under Sec. 933. The manager makes the election by reporting on his income tax return for 2022 the gain in accordance with the source allocation rules in Regs. Sec. 1.937-2(f)(1)(vi).

Property other than marketable securities: For property other than marketable securities, the portion of the gain that can be allocated under the election to Puerto Rican sources depends on the proportion of days over the entire holding period that the taxpayer is a bona fide resident of Puerto Rico. Thus, the appreciation of the asset is spread ratably over the holding period, regardless of when the actual appreciation in value occurred. A bona fide resident in Puerto Rico who only recently moved to Puerto Rico can allocate only a small portion of the gain to Puerto Rico if the holding period greatly exceeds the period during which he or she is a bona fide resident of Puerto Rico before the sale.

The rule for pro rata allocation for property other than marketable securities can result in distortions. For example, if most or all the appreciation of an asset occurs during the taxpayer’s residency in Puerto Rico, but the holding period extends long before that residency commenced, then much of the gain will be U.S.-source income even though the growth occurred after bona fide residency was established. For such assets that have an extensive holding period over several years before residency commences in Puerto Rico, this election may not provide much relief from U.S. tax liability.

Significant savings possible

While the tax benefits of moving to Puerto Rico are attractive, interested individuals should understand that the benefits primarily apply to income and activity occurring during residence in Puerto Rico. Hence, persons who can operate businesses in Puerto Rico, particularly those who qualify for Puerto Rico tax incentives, can dramatically reduce their potential tax liabilities by moving their lives and businesses to Puerto Rico. U.S. persons seeking only to minimize or eliminate taxes on unrealized gains and appreciation in their business interests prior to their move may find the U.S. exemption and Puerto Rican incentives of little use.

The recent IRS campaign will focus in part on former U.S. residents now living in Puerto Rico who incorrectly exclude income that is not Puerto Rican-source income covered by Sec. 933. Therefore, U.S. taxpayers who intend to take advantage of the tax benefits of bona fide residence in Puerto Rico should evaluate whether their anticipated gains on significant sales or other dispositions qualify as Puerto Rican-source income excludable under Sec. 933.

EditorNotes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact Douglas.Borg@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.