A bona fide resident of Puerto Rico may generally exclude income derived from Puerto Rican sources from U.S. taxable income. Since only income sourced within Puerto Rico qualifies for this exclusion, it’s crucial to understand which types of income are considered Puerto Rican-sourced and which are not.
The rules for sourcing income differ depending on the category. Common income categories include:
- Interest
- Dividends
- Compensation for personal services
- Income from the sale or exchange of real property
- Rentals and royalties
- Income from the sale or exchange of personal property
Interest Income
Interest income is typically Puerto Rican-sourced if paid by a resident or corporation of Puerto Rico. However, interest received from a U.S. corporation or resident is considered U.S.-sourced and does not qualify for the exclusion from U.S. taxable income.
Dividend Income
Dividends are usually classified as Puerto Rican-sourced if paid by a Puerto Rican corporation. Dividends from a U.S. corporation, however, are treated as U.S.-sourced income and are taxable in the U.S.
Compensation for Personal Services
Compensation is sourced based on the location where services are rendered. Income earned from services performed in Puerto Rico is considered Puerto Rican-sourced, whereas compensation for work performed outside of Puerto Rico is not.
Sale or Exchange of Real Property
Profits from selling real property located in Puerto Rico are Puerto Rican-sourced and can be excluded from U.S. taxable income. In contrast, profits from selling property outside Puerto Rico are not Puerto Rican-sourced and remain subject to U.S. tax.
Rental & Royalty Income
Income from renting or licensing property in Puerto Rico is considered Puerto Rican-sourced. However, income from property located or used outside Puerto Rico is not. For bona fide Puerto Rican residents, rental or royalty income from foreign property is taxable in the U.S.
Appreciated/Tainted Property
Special rules apply to gains from selling certain properties owned before establishing Puerto Rican residency. If the property is sold within 10 years of becoming a bona fide resident, the gains are typically not Puerto Rican-sourced and are taxable in the U.S.
Puerto Rican residents can elect to split the gains from tainted property using a mark-to-market method for securities and a time-based method for other properties. The election must be reported on the U.S. tax return for the year the property is sold.
Sale or Exchange of Personal Property
The rules for personal property vary depending on whether the property is inventory. If inventory is manufactured in Puerto Rico, the sales income is Puerto Rican-sourced. However, if inventory is manufactured outside Puerto Rico, the income is not Puerto Rican-sourced. For non-inventory personal property, the income is generally Puerto Rican-sourced.
Marketable Securities
Marketable securities (e.g., publicly traded stock) are considered Puerto Rican-sourced if the holding period includes time spent in Puerto Rico. The gain is calculated based on the difference between the fair market value at the beginning and end of the Puerto Rican holding period.
Property (Excluding Marketable Securities)
For non-securities property, the gain attributable to Puerto Rico is calculated by multiplying the total gain by a fraction. The numerator is the number of days in Puerto Rico, and the denominator is the total number of days the property was held.
Income Earned Through Partnerships & S Corporations
Income from partnerships and S corporations is generally passed through to partners or shareholders and treated as if earned by them directly. When determining the source of income for a Puerto Rican resident, the income is sourced where the partnership or corporation generated it.
For S corporations, which are typically treated like partnerships for tax purposes, the income passed through to shareholders may be classified as Puerto Rican-sourced based on the business activities conducted in Puerto Rico.
Allocation of Expenses to Puerto Rican-Sourced Income
When Puerto Rican-sourced income is excluded from gross income under Code §933, related deductions or losses cannot be deducted for U.S. tax purposes. The allocation of expenses is governed by the rules in Treas. Reg. §1.861-8. These regulations allow taxpayers to allocate deductions between Puerto Rican-sourced income and non-Puerto Rican-sourced income based on various factors, including sales, costs, or profits.
For example, if 80% of a business’s gross income comes from Puerto Rican sources, then 80% of the related expenses may be allocated to Puerto Rican-sourced income, and this portion cannot be deducted for U.S. tax purposes.
The method of apportionment must reflect the factual relationship between the expenses and the income sources, and taxpayers must provide supporting documentation if requested.