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Expatriation Lite: Leaving the U.S. Tax System While Retaining Your Citizenship

As many Miami residents who earn income abroad may be aware, the United States is one of only two countries in the world that taxes its citizens and residents (collectively, “U.S. taxpayers”) on their worldwide income.  Therefore, a U.S. taxpayer that earns only foreign source income will be subject to U.S. federal income tax on that income.  Furthermore, a U.S. taxpayer that resides outside of the United States also will be subject to U.S. federal income tax on all of its income, regardless of the source of such income.

Expatriation and Alternatives

Many U.S. taxpayers who spend a significant portion of their time outside of the United States each year and who earn predominantly foreign source income have considered “expatriating” from the United States in order to avoid paying U.S. tax on their worldwide income.  Under the current expatriation rules, a U.S. citizen or “long-term” green card holder is treated as if he or she sold their worldwide assets for fair market value on the day before they gave up their citizenship or their green card.  While it generally would make sense from a U.S. federal income tax perspective for such U.S. taxpayers to consider expatriating from the United States, many people would probably not want to give up their citizenship or green card simply to reduce their U.S. federal income tax liability. 

As an alternative to expatriation, U.S. citizens who become “bona fide” residents of Puerto Rico have long been able to retain their U.S. citizenship and still eliminate U.S. federal income tax on income derived from Puerto Rican sources, such as interest and dividends. (emphasis added).  Furthermore, by becoming a resident of Puerto Rico, U.S. citizens were also able to completely avoid U.S. federal income tax on capital gains, including U.S.-source capital gains.  Until recently, however, the benefits of relocating to Puerto Rico were limited because, even though exempt from U.S. federal income tax, the interest, dividends, and capital gains continued to be subject to Puerto Rican income taxes.  With the recent changes to the Puerto Rican tax laws, Puerto Rico now presents a unique opportunity for certain U.S. taxpayers to avoid paying any income tax on interest and dividends from Puerto Rican sources, as well as completely avoid paying U.S. and Puerto income tax on all long-term capital gains, including U.S.-source capital gains, while still retaining their U.S. citizenship.

Investment Income Exemption

On January 17, 2012, Puerto Rico enacted the “Act to Promote the Relocation of Individual Investors to Puerto Rico” (the “Act”), which generally exempts new residents of Puerto Rico from tax on certain long-term capital gains, as well as Puerto-Rican sourced interest and dividends.  A U.S. citizen generally can qualify for this income tax exemption by becoming a “bona fide” resident of Puerto Rico, so long as they were not a resident of Puerto Rico at any time during the 15 year period ending on January 17, 2012.  The term bona fide resident means a person who: (i) is present for at least 183 days during the taxable year in Puerto Rico, (ii) does not have a tax home outside of Puerto Rico during the taxable year; and (iii) does not have a closer connection to the United States or a foreign country than to Puerto Rico.

To qualify for the income tax exemption, a U.S. citizen must enter into an agreement with the Puerto Rican government, which sets forth the details of the tax exemption, including the effective period of the exemption.  The effective period generally begins on the date the individual is domiciled in Puerto Rico and ends on December 31, 2035.  

The income tax exemption is only applicable to long-term capital gains attributable to the increase in the value of securities after the date that the individual establishes domicile in Puerto Rico. Therefore, long-term capital gains recognized during the exemption period from the sale of securities acquired during the exemption period would be exempt from Puerto Rico income tax.  More importantly for U.S. citizens, the long-term capital gains exempt from Puerto Rico income tax, generally will also be exempt from U.S. federal income tax.

Who Can Benefit the Most from this Exemption?

High-net worth individuals with significant capital gains from stocks and securities, as well as hedge fund managers and other owners of financial businesses, likely have the most to gain from a move to Puerto Rico.  With the combination of the Puerto Rico income tax exemption provided by the Act, the recent increase in capital gains rates in the United States from 15 percent to 20 percent, and the imposition of the new 3.8 percent Medicare tax on net investment income, certain U.S. citizens may now have all the incentive they need to make the move to Puerto Rico.