A bona fide resident of Puerto Rico is generally allowed to exclude “income derived from sources within Puerto Rico” from U.S. taxable income. Since only Puerto Rican-sourced income qualifies for this exclusion, it is essential to distinguish which types of income are, and are not, considered Puerto Rican-sourced.
The classification of income source varies by category, with specific rules applied to common categories, such as:
- Interest,
- Dividends,
- Compensation for personal services,
- Income from the sale or exchange of real property,
- Rentals and royalties, and
- Income from the sale or exchange of personal property.
Interest Income
Interest income is generally considered Puerto Rican-sourced if it is paid by a resident of Puerto Rico or a Puerto Rican corporation. However, if a bona fide Puerto Rico resident receives interest from a U.S. corporation or resident, that income is regarded as U.S.-sourced and cannot be excluded from U.S. taxable income.
Dividend Income
Dividend income is usually classified as Puerto Rican-sourced when paid by a Puerto Rican corporation. Conversely, dividends received by a bona fide Puerto Rican resident from a U.S. corporation are treated as U.S.-sourced and are not excluded from U.S. taxable income.
Compensation for Personal Services
Compensation is sourced based on where the services are performed. Earnings for work done in Puerto Rico are generally treated as Puerto Rican-sourced, while compensation for services split between Puerto Rico and other locations is allocated accordingly. Only the Puerto Rican portion of such income may be excluded from U.S. taxable income.
Sale or Exchange of Real Property
Gains from the sale of real estate in Puerto Rico are considered Puerto Rican-sourced and may be excluded from U.S. taxable income. In contrast, gains from real estate sold outside Puerto Rico are not Puerto Rican-sourced and remain taxable.
Rental & Royalty Income
Rental and royalty income is sourced based on the property’s location or use. Income from property located or used in Puerto Rico is Puerto Rican-sourced, while income from property used outside of Puerto Rico is not. For a bona fide Puerto Rican resident, rental or royalty income from property outside Puerto Rico remains taxable in the U.S.
Appreciated/Tainted Property
Special rules apply to gains from the sale of certain investment property owned before establishing Puerto Rico residency (“Tainted Property”). Gains from Tainted Property sold within 10 years of becoming a bona fide Puerto Rican resident are generally treated as non-Puerto Rican-sourced and cannot be excluded from U.S. taxable income.
Puerto Rico residents can elect to split Tainted Property gains, using a mark-to-market allocation for securities and a time-based allocation for other property. The gain is split between the U.S. and Puerto Rican holding periods, with the Puerto Rican period covering ownership while residing in Puerto Rico. The allocation election is reported on the U.S. tax return for the year of disposition.
Sale or Exchange of Personal Property
Different rules apply based on whether the property is considered inventory. Income from the sale of inventory manufactured by the taxpayer in Puerto Rico is Puerto Rican-sourced, while income from inventory manufactured outside Puerto Rico is not. For purchased inventory, income is Puerto Rican-sourced if the title transfers in Puerto Rico and not if it transfers elsewhere.
Generally, income from the sale of personal property (non-inventory) by a bona fide Puerto Rican resident is Puerto Rican-sourced, subject to specific exceptions.
Marketable Securities
Marketable securities are securities that are actively traded on an established financial market, such as publicly traded corporate stock. To qualify, the securities must remain marketable for the entire duration of the individual’s holding period.
The gain associated with the Puerto Rican holding period is calculated as the difference between the security’s fair market value at the start of the Puerto Rican holding period and its fair market value at the time of sale. This gain is considered Puerto Rican-sourced income.
Property (Excluding Marketable Securities)
For property other than marketable securities, the gain attributed to the Puerto Rican holding period is calculated by multiplying the total gain by a fraction. In this fraction, the numerator is the number of days in the Puerto Rican holding period, and the denominator is the total number of days the property was held overall.
Income Earned Through Partnerships & S Corporations
Partnerships and S corporations are typically not taxed on their income directly. Instead, their income is passed through to the partners or shareholders, who are then responsible for paying taxes on it.
With certain exceptions, the nature of income passed through to partners or S corporation shareholders is treated as if it were earned directly from the source where the partnership or S corporation generated it.
When a partner’s portion of gross income needs to be identified, they receive an allocation of their share of the partnership’s gross income. For example, a partner may need to include their share of partnership gross income when calculating their Puerto Rican-sourced income. Similar rules apply to S corporation shareholders.
For bona fide residents of Puerto Rico, it’s crucial to understand that certain partnership personal property sales are attributed to the partner’s place of residence.
For certain types of foreign-sourced income, an S corporation is classified similarly to a partnership, and its shareholders are considered partners. This treatment applies specifically under subparts A and F of part III, and part V, of subchapter N in Chapter 1 of the Internal Revenue Code. However, Code §937, which covers income sourcing rules for bona fide residents of Puerto Rico, is located in subpart D of part III of subchapter N—not in subparts A or F.
As a result, an S corporation is not regarded as a partnership when determining the source of entity-level gains on sales of personal property under Code §937. In practical terms, this means that the rule attributing partnership personal property gains to the residence of the partner does not apply to personal property gains recognized by S corporations for Code §937 purposes.
Allocation of Expenses to Puerto Rico Sourced Income
When income is excluded from gross income under Code §933, any related deductions or losses that pertain to that excluded income cannot be deducted. To determine which portion of expenses should be allocated to the excluded income, the allocation and apportionment rules under Treas. Reg. §1.861-8 apply.
According to Temp. Treas. Reg. §1.861-8T(c)(1):
A deduction is apportioned by attributing the deduction to gross income [..] which is [Puerto Rican source income] and to gross income […] which is [non-Puerto Rican source income]. Such attribution must be accomplished in a manner which reflects to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.
The regulation provides several ways to apportion deductions, allowing taxpayers to use various bases and factors as long as the chosen approach accurately represents the connection between the deduction and the income groups. Possible methods include comparing: (1) units sold; (2) gross sales or receipts; (3) cost of goods sold; (4) profit contribution; (5) expenses, assets, salaries, space, and time related to generating the income; and (6) gross income amounts. Taxpayers must provide, if requested, information supporting their chosen method of apportionment.
If a taxpayer has a business expense that relates to both Puerto Rican and U.S.-sourced income, they may allocate it across both groups based on the total gross income generated by the business. For example, if 80% of a business’s gross income comes from Puerto Rican sources, then 80% of the expense may be allocated to Puerto Rican-sourced income. This allocated portion cannot be deducted for U.S. tax purposes.
Regardless of the method used, it must closely reflect the actual relationship between the deduction and the gross income grouping.