A few years ago, in order to encourage investment in Puerto Rico, the legislative assembly passed Act 20 and Act 22. Act 20 provides tax benefits for founding a Puerto Rico company, Act 22 offers tax benefits for entrepreneurs and investors willing to move to Puerto Rico. This post will cover the details of Act 22.
First, a few disclaimers: I am not a lawyer or an accountant, and while I have no idea what the rules are regarding giving advice, you should assume that I’m not doing that. If you want to take advantage of either of these acts, you should find a lawyer or an accountant. Having said that, I will warn you that the vast majority of lawyers and accountants have no idea how these acts work (I’ve been through several), so you should probably look for somebody who practices in Puerto Rico. Finally, while the law is aimed at hedge funds and finance types, I’m going to talk about how the benefits apply to entrepreneurs.
In a nutshell, Act 22 provides a 0% capital gains rate for anyone willing to move to Puerto Rico and establish residency on gains that are accrued while in Puerto Rico. It further provides tax-free interest and dividends ONLY for Puerto Rico source income (that means interest paid by Puerto Rican entities or dividends issued by Puerto Rican companies).
How can this be possible? It turns out that through a curiosity of the tax code, Puerto Rico is one of the few places in the world that is exempt from paying US income tax on Puerto Rico source income. If, for example, you move to Germany instead, you must pay German income taxes on your income. Then you must pay US income taxes on any amount above what you paid in Germany. Puerto Rico gets to run their own show.
The fine print on the benefits:
- You get 0% tax rate on both short and long-term capital gains on your assets only after you establish bona fide residency in Puerto Rico. This process is complicated (see page 3 of IRS publication 570). However, the important part is that the key date is the earliest date when you move to Puerto Rico and are able to satisfy the three-part test. The simplest way to satisfy the three-part test is:
- be present for at least 183 days during the taxable year in Puerto Rico
- do not have a tax home outside of Puerto Rico during the taxable year
- do not have a closer connection to the United States or a foreign country than to Puerto Rico.
- Any capital gain that you had before moving to Puerto Rico gets treated in one of two ways:
- If your assets are considered marketable securities, then whenever you sell them you will have to pay US income taxes on the portion that was accrued before your move. Example: You have stock in Corporation A which is worth $1000 the day you leave the United States. If you later sell the stock in Puerto Rico for $3000, you have to pay US income taxes on the first $1000 and then 0% Puerto Rico tax on the remaining $2000.
- If your assets are something else (e.g. privately held stock) they are considered “other personal assets” and gains need to be allocated between the portion of the time you held the stock in the US and the time you held the stock in PR (see page 9 of IRS publication 570). The US portion is going to be subject to normal US capital gain tax rates and the PR portion is to be exempt from local and federal taxes. Example: You hold stock in a private company A for five years before moving to Puerto Rico. 180 days after moving to Puerto Rico, you sell the stock for a gain. You pay US income tax on (5*365)/(5*365 + 180)= 91% of the gain, and you pay 0% Puerto Rico taxes on (180)/(5*365+180) = 9% of the gain.
What you need to do:
- If you want bona fide residency in Puerto Rico for the current year, you must move to Puerto Rico with 183 days left in the year AND remain a bona fide resident of Puerto Rico for three subsequent years. The 183 day rule is the most straightforward rule, but there are several others that can be used.
- If you are willing to forgo the benefits of the first year, it appears that you can make a decision year-to-year as to whether to stay.
- You must apply for a contract with the Puerto Rican government under Act 20 or Act 22. I’m told the application process takes approximately 3 months, and you can apply before or after you move to Puerto Rico. I’m told that unless you fail the criminal background check or simply don’t have any assets that would make sense under the Act, your likelihood of approval is very high.
- In order to remain a bona fide resident of Puerto Rico for subsequent years, you must continue to meet the three-part test.
Other things to be aware of
- The Puerto Rico estate/gift tax is 10% over $1 million, as opposed to 40% over 5 million for the United States. Moving to Puerto Rico will reduce the amount you can give away tax-free by 80%.
- If you apply for and are approved for treatment under Act 20 or Act 22, you receive a contract from the Puerto Rican government that lasts until December 31, 2035. The upshot is as far as anyone knows the only way that your deal can be rescinded is if the US government changes US tax law to take out the Puerto Rican exemption from US federal taxes.
- You must file IRS form 8898 when you leave the United States and assume Puerto Rico residency.
- The Puerto Rican economy and government are in dire straits. There is concern that they may default on their bonds. That’s the whole reason why they are making such an attractive offer.
- Along with the economic troubles, Puerto Rico has seen net negative migration. Fewer people chasing more homes have caused property prices to plummet over the last few years, so caveat emptor.