Stop Letting the Rich Move to Puerto Rico as a Tax Haven

Edward Kleinbard, a professor of law at the Gould School of Law of the University of Southern California, served as chief of staff of the Congress’ Joint Committee on Taxation.

Updated April 14, 2015, 6:45 AM

Now that you’ve created the next great app and your investment in your startup is worth a billion dollars, at least on paper, it’s time for a really difficult challenge: how to cash out without paying capital gains taxes anywhere in the world?

With no U.S. or Puerto Rican tax on much investment income of new residents, U.S. citizens now can pay zero tax on capital gains.

For several hundred affluent Americans over the last couple of years (including Toby Neugebauer, a key financier to Ted Cruz) the answer has been to establish a principal residence in Puerto Rico, and spend 183 days a year there.

The commonwealth is an unincorporated part of the United States, and its residents are U.S. citizens. Nonetheless, the United States treats Puerto Rico as a foreign country for tax purposes. And, unlike the case of U.S. citizens residing in genuinely foreign countries, the United States does not impose any federal income tax when U.S. citizens who are residents of the island earn income from Puerto Rican sources.

Puerto Rico can tax its residents, but in a move to attract affluent Americans to take up residence there, the island in 2012 adopted Act 22, which basically exempts most investment income of new residents from Puerto Rican tax.

What all this means is that capital gains arising after relocating to Puerto Rico are exempt from taxes everywhere in the world. A taxpayer’s built-in (unrealized) capital gains at the time of his relocation (like our hypothetical billionaire’s paper gains on his startup company) require a bit more patience, but after 10 years the only tax on sale is a 5 percent Puerto Rican capital gains tax on those pre-relocation accrued gains.

And what billionaire looking to save hundreds of millions of dollars in capital gains taxes will not be able to afford to be patient? He is not required to spend all his time on the island, and he is as free to travel within the United States and around the world on his U.S. passport as much as the next U.S. citizen. For those days his tax lawyers command him to be present in Puerto Rico, well, how hard a lifestyle is it, choosing between beach and poolside?

The law here is clear, and the only risks are political (that Congress or the Puerto Rican legislature amend their respective tax laws to close down this loophole). But the costs of rolling the dice on the politics are minimal for a superaffluent taxpayer with a big potential capital gains tax bill — sell the homes in Atherton and Telluride, and buy an ocean view estate on the island. (You can always rent a ski lodge for a few weeks in the winter anyway.) With great wealth comes great capital gains evasion opportunity.