Puerto Rico’s Tax Loophole: How to Pay the Feds Zero

Did you know the U.S. has its own colonies?

It does… and living in one of them in particular creates fantastic tax benefits unavailable to U.S. citizens anywhere else in the world.

The U.S. acquired Puerto Rico in 1898, after it won the Spanish-American War. Ever since, it’s been an “unincorporated” territory of the U.S.

Puerto Rico is sovereign U.S. territory. Although its residents are U.S. citizens, they don’t have full constitutional rights. They can’t vote for president. Puerto Rico’s representative can’t vote in the House of Representatives. They have no Senators. The island has its own government, but Congress can overrule it at will.

But the quid pro quo is that Puerto Ricans don’t pay federal income tax on income earned on the island.

As Puerto Ricans are U.S. citizens, they can travel freely anywhere in the U.S. and settle there if they wish. Once they do, they become a citizen of one of the U.S. states, enjoying full rights… and becoming liable for federal income tax.

But the opposite is also true. Any U.S. citizen or permanent resident can become a resident of Puerto Rico by establishing a bona fide presence there.

As you may imagine, the IRS watches for abuse of Puerto Rico’s unique tax status. Being a bona fide resident means more than just staying on the island for a while. You need to have a home there—either by ownership or long-term lease—as well as basic life connections like a bank account, utility bills, a driver’s license, and other attachments to the local society. If you have a home on the mainland, it should preferably be rented out and unavailable for your own use.

You can probably see where this is headed. If you become a Puerto Rican resident, you are exempt from federal income tax. In many cases, you don’t even have to file a tax return.

That makes Puerto Rico one of the only places on earth where a U.S. citizen can be completely exempt not only from federal income tax, but also from interacting with the IRS at all.

What About Puerto Rican Tax?

Being exempt from federal income tax doesn’t mean paying no tax at all, of course.

Because it isn’t a state, Puerto Rico doesn’t benefit from federal venue sharing schemes like a U.S. state (Medicaid block grants, for example). Its government depends on income and other taxes on its residents to fund itself.

The problem is that average incomes are much lower than on the mainland, so Puerto Rican residents hit higher income tax brackets on much lower earnings. On the mainland, a single filer hits a 32% tax bracket at taxable income of $182,100. In Puerto Rico, you’re paying a 33% marginal rate when you hit $61,501.

That doesn’t sound so good. But the island has attractive tax rates for the self-employed. As long as 80% of your income derives from services, like consulting, your tax rates on that portion of your income are dramatically lower than on the mainland. The highest rate for a single filer is 20% on income over $500,000.

And it gets much better…

A Clever Response

Puerto Rico has had budget problems for years… and the fault lies with Congress. In 1996, a bipartisan majority unilaterally terminated tax incentives for mainland businesses to relocate there. These incentives had created a thriving pharmaceutical sector in Puerto Rico, employing thousands of people and contributing significantly to the island’s budget. Their withdrawal devastated that budget.

Puerto Rico’s government got creative. In 2012, it adopted two incentives to encourage mainlanders to move themselves and their businesses to the island, stimulating economic activity and boosting overall tax revenues.

Both are available to any person—including you—who wasn’t a resident of Puerto Rico for the 10 tax years before July 1, 2019, and who becomes a bona fide resident of the island before December 1, 2035.

Individual Resident Investor Incentive

The first incentive targets individual mainlanders with tax benefits to encourage them to become residents of the island. These include:

• No Puerto Rican tax on interest and dividends from any source.

• No Puerto Rican capital gains tax on appreciation of assets (stocks or real estate) accrued after you’ve become a resident.

• 5% tax on long-term capital gains accrued before you become a resident if you sell during your first 10 years as a resident. If you hold on to those assets for 10 years, you’ll pay no capital gains tax on them afterward.

• No gift or estate taxes.

• No tax on gains from crypto.

The upshot is that you are exempt from numerous tax categories that apply to most Puerto Ricans. The rationale behind this is that mainlanders who establish residence on the island will spend money there, stimulating the economy and ultimately replacing direct taxes.

These incentives are most attractive to two categories of mainlanders.

The first is people in service occupations whose clients are located outside of Puerto Rico. The combination of the incentives, the island’s concessionary tax rates for service professionals, and the absence of federal income tax is a massive savings relative to the mainland.

The second is retirees from high-tax states, like California and New York. The tax concessions on interest, dividends, and capital gains mean huge savings.

Of course, there are some “terms and conditions” for the Individual Resident Investor Incentive:

• You must purchase a home within two years of moving to the island and live in it. You cannot simply invest in property and rent it out.

• You’ll be liable for municipal property taxes: land (3%), real estate (1.03%) and personal property (1%).

• You will still be liable for federal income tax on any earned or unearned income from the mainland, including dividends or businesses you own there.

• Realized capital gains accrued before you move to Puerto Rico are still subject to U.S. federal income tax.

• If you have any income from outside Puerto Rico, whether earned or unearned, you must file a tax return, even if you don’t owe tax.

• If you are an employee, even of a Puerto Rican employer, you will still have to pay federal Social Security and Medicare taxes.

Export Services Incentive

The Export Services Incentive is designed to attract service businesses to the island.

To qualify, you must either start a new business or move an existing one to the island. The business must provide services to clients outside of Puerto Rico. Any income from services supplied to locals is subject to normal Puerto Rican tax.

Typical examples include financial services, consulting, auditing firms, marketing, and any other service activity that can be provided remotely.

The benefits of the Export Services Incentive include:

• A 4% corporate tax rate.

• No tax on dividends, including those paid by the business to its owner.

• 50% tax exemption on municipal taxes.

• 75% tax exemption on municipal property taxes (small and medium businesses receive a 100% exemption during their first five years of operation).

• No tax on capital gains accrued after the business relocates to Puerto Rico.

• No tax on gains from crypto.

The “terms and conditions” include:

• The business owner must pay him or herself a reasonable salary and pay Puerto Rican income tax on that amount. Obviously, the idea is to pay the lowest salary you can, and to take the rest of your business income in dividends.

• Businesses with annual turnover over $3 million must include at least one Puerto Rican employee, which can be the business owner.

• Businesses must still pay Social Security and Medicare taxes for their employees.

It’s easy to see why the Export Services Incentive would be so attractive to financial firms especially. Big hedge fund managers paying millions on their earnings on the mainland can move their operations to the island, pay themselves a minimal salary, and enjoy unlimited tax free dividends.

But these incentives apply to any type of business. Let’s say you are a freelance computer code writer. You move to the island and create a limited liability company for your services. You pay yourself the lowest salary you can. You draw the bulk of your income as dividends from your business. You can thus effectively avoid most income taxes entirely.

What’s the Catch?

In recent years, there’s been predictable pushback against these incentives, both from within Puerto Rico and Congress.

Locals resent paying more tax than mainlanders, whilst Congress is unhappy that tax revenues that would have gone to the federal government disappear once the taxpayer moves to the island.

Despite this, both incentives are legally binding on both the Puerto Rican government and the applicant. They’re styled as contracts between the two parties and can’t be changed without the consent of both.

So, even if the laws were to change and the incentives withdrawn, they would still apply for the terms of the original agreement. But change doesn’t seem likely. Between 5,000 and 6,000 mainlanders apply for the incentives annually.

Instead of changing the law, the Puerto Rican government has introduced what some have called a “backdoor tax” to holders of the incentives. It can do this because the contracts include a provision that allows the government to adjust the fees involved with maintaining the programme on an ongoing basis.

In addition to a $750 application fee, there is now a $5,000 acceptance fee. But the real backdoor element is the requirement to make a total of $10,000 in donations to Puerto Rican charities every year that the incentive holder is in Puerto Rico. This is intended to weed out marginal migrants from the mainland who would be unlikely to contribute much to the local economy.

Nevertheless, for many mainlanders the numbers will work out and produce significant tax savings.

And—as mainlanders who’ve moved to the island have told me repeatedly—life in Puerto Rico is about a lot more than just tax savings. It’s a beautiful Caribbean island with gorgeous beaches, and tropical rainforests—just a short hop from the mainland itself.