A tax expert shares the misconceptions and hidden costs the wealthy face when moving to Puerto Rico for tax breaks

• Puerto Rico's Act 60 offers tax incentives and is attracting wealthy Americans to the island.
• However, there are misconceptions about what gains are exempt.

Puerto Rico offers an enticing proposition for wealthy Americans from the mainland seeking tax relief, but making the move can be challenging if you are not familiar with all the rules.

Clarissa Cole, a managing director at the tax advisor firm Anderson — which specializes in expatriation consequences and planning, especially for high net-worth individuals — said some of the important details often missed or overlooked include residency, investments, and charitable contributions.

Between 2021 and 2022, about 27,000 individuals moved from the US mainland to Puerto Rico, according to data collected by the US Census Bureau. Act 60, which provides financial incentives to entice Americans to move to Puerto Rico full-time for an extended period, has been a lure for some wealthy Americans seeking financial benefits without having to give up US citizenship.

If you qualify for an Act 60 decree, it includes a 4% income tax rate, a 75% discount on property tax, and no tax on capital gains accrued while on the island.

At its core, Puerto Rico's Act 60 aims to invigorate its economy by attracting foreign residents and investors, especially those with a lot of money. However, to get the Act 60 benefits, you have to become what is called a "bona fide" resident.

Common misconceptions of the Puerto Rico tax breaks

Cole said one of the biggest misconceptions from people seeking tax breaks in Puerto Rico is that all gains from the selling of assets, such as a house or investments, are excluded once the person becomes a bona fide resident of the island. However, the true tax break is determined by how much of the gains came after becoming a resident, and this is determined by a special rule called the "possession holding period."

Cole explained that the "possession holding period" is the key and means that only gains made while living in Puerto Rico are exempt from the US capital gains tax. She noted that this is also true for those who qualify for citizenship for the entire year, but only lived on the island for a portion of that time.

For Sean Flynn and Sarah Lindsey, a semi-retired couple who moved from Texas to Puerto Rico, that means keeping a detailed log of asset values before they moved and how much they have changed each year after becoming residents.

"I have to keep track of the day that I moved here and the gains that I had up until that point," Flynn said. "So if I sell an asset that I owned before I moved, I have to keep track of that and say, 'Oh, I had a gain that was not while I lived in Puerto Rico.'"

After moving to Puerto Rico, the couple sold their condo in Austin, a move that was not exempt from capital gains tax. However, the condo they purchased on the island after moving will be free of the tax if it accrues value by the time they sell.

According to Cole, another misunderstanding is income tax and what is eligible for the lower rate. Similar to the capital gains tax exemption, only income from sources within Puerto Rico qualify for the lower rate.

The same is true for income derived from a business being operated in the US territory. The lower tax rate only pertains to income received for services exported from Puerto Rico.

However, there are some gray areas that people may seek to avoid for the sake of being safe. For example, Flynn, who owns an IT consulting business, AFI Technologies, has been advised that if he conducts business while visiting the 50 states, that could be viewed as a service not exported from Puerto Rico and therefore not applicable for the lower income tax rate even those his business is registered on the island.

The tax incentives are designed to lure the wealthy

The tax breaks are nice, but not everybody can afford them.

Cole said that another rule that often surprises people is they can't claim the tax breaks if they have previously lived on the island, moved away, and returned within 10 years. Additionally, those seeking tax breaks must give $10,000 annually to specific Puerto Rico-based charities and purchase a residence on the island within two years of moving to Puerto Rico.

The latter two requirements help ensure that those seeking the tax breaks have higher net worths to contribute to Puerto Rico's economy.

"Act 60 was designed to promote economic growth in Puerto Rico by encouraging foreigners to move to the island for extended periods of time," Cole said. "It's therefore designed to benefit the Puerto Rican economy the most and is structured to attract those more likely to positively impact the local economy to relocate to the island."

With the tax breaks comes extra scrutiny from the IRS

One downside, according to Cole, is the same people the island is trying to attract will automatically attract the attention of the IRS.

"Focus from the IRS often begins with the identification of those applying for Act 60 benefits, filing change of address requests to Puerto Rico, claims of exemption, and nonfilers," Cole said. She added that once somebody is under the IRS's radar, investigations may include the inspection of travel records, credit card purchase locations, and income sources.

Those who do get caught not adhering to the rules may be subjected to what Cole described as a "significant monetary and criminal penalty."

Cole shared a common piece of advice given by others who live on the island: visit the island ahead of time and talk to people who have already made the move.

However, she also added that it is important to speak with tax professionals on the mainland and in Puerto Rico so that there are no surprises.

If you moved to Puerto Rico for tax incentives and want to share your experiences, contact this reporter at cgaines@businessinsider.com.