Law incentivizes wealthy to move to Puerto Rico

In "The Last Tycoon," F. Scott Fitzgerald said, “There are no second acts in American lives.” The meaning of this is debated by Fitzgerald scholars.

What is clear is that there is a special 22nd Act in the Puerto Rican tax laws. The so-called “Act 22” is intended to encourage relocation to the island. Puerto Rico is a U.S. territory. It has its own tax system. U.S. citizens are taxed on worldwide income, which is without regard to its source (foreign or domestic).

A special provision of U.S. tax law, Section 933, allows bona fide residents of Puerto Rico to avoid U.S. tax on income sourced in Puerto Rico.

Section 933 only applies to the U.S. tax — the citizen residing in Puerto Rico is still subject to Puerto Rico tax on that income.

Act 22 was enacted in 2012. It offers special tax treatment to people who did not reside on the island between Jan. 17, 2006, and Jan. 17, 2012.

If you become a resident of Puerto Rico after Jan. 17, 2012, you can enjoy a tax exemption for certain investment income earned after becoming a resident.

Why after that date? Because the purpose of the law was to encourage you to move. If you already lived in Puerto Rico, you did not need the incentive.

Act 22 says you pay no Puerto Rico tax on certain interest, dividends and capital gains.

To qualify, the income must be earned after you relocate. That includes only capital gains that accrue from gains after your move.

If you have stock that appreciated in value before the move, the pre-move gains are generally taxed.

However, a special 10% capital gains rate applies if you sell the stock within 10 years of moving. If you don’t sell until after 10 years, the rate drops to 5%.

But the real advantage is avoiding any tax at all on your dividends, interest and capital gains accruing after the move.

As a U.S. citizen, you would normally still pay federal income tax on the earnings.

But Section 933 of U.S. law says you only must worry about the Puerto Rico tax law. That means you can use two separate exemptions to pay no tax at all. Section 933 eliminates U.S. tax. Act 22 eliminates Puerto Rico tax.

Of course, that is most valuable to those with substantial dividends, interest and capital gains. We usually call those people “wealthy.”

And you still must qualify for the Act 22 exemption. That requires you become a resident of Puerto Rico.

Resident status requires that you be physically present for 183 or more days during the year. You also cannot have a tax home elsewhere.

You also must be a good citizen. You must contribute $10,000 annually to local not-for-profit organization. You must buy a home within the years of the move.

To receive a tax benefit more than the required contribution, your passive investment income needs to be large. So, you should be “wealthy.”

Now imagine lots of wealthy people start relocating to Puerto Rico. They need a place to live to establish residency. Wouldn’t that tend to drive up housing costs?

Critics of Act 22 said a resounding yes. Puerto Rico is often in the path of tropical storms and hurricanes.

In September 2017, the island got hit with a Category 4 hurriance named Maria. An estimated 2,975 people were killed.

Hurricane Maria caused many people to leave the island. Nonetheless, rent prices and housing costs have soared.

Perhaps that is the price that one pays for bringing new residents and investment dollars to the island.

But some members of Congress now want Act 22 investigated by the IRS.

Specifically, to determine whether people meet the residency requirements.

Also, critics argue the required charitable gift feature of Act 22 is not always complied with.

Section 933 creates an unusual result of treating a U.S. territory as if it were a foreign country. You pay tax in one place, but not in both.

Puerto Rico is free to not collect its tax if it chooses. But it is important that the provisions of Act 22 are satisfied. One more thing for the IRS to study.