For many high earners exploring Puerto Rico’s Act 60 incentives, the tax benefits are compelling. But the incentives aren’t automatic, and understanding the three pillars of compliance — residency, sourcing, and substance — is essential to both qualify and remain compliant over time.
1. Bona Fide Residency
At the heart of Act 60’s individual benefits is bona fide residency. The tax incentives — including potential exemptions or preferential treatment on certain income — hinge on meeting specific tests established under the Internal Revenue Code and interpreted in IRS guidance.
Under IRS rules, an individual must satisfy three residency tests each tax year:
- Presence Test — Generally interpreted as spending at least 183 days in Puerto Rico during the tax year, though alternative criteria apply when viewed over multi-year periods.
- Tax Home Test — Your tax home must be in Puerto Rico, meaning your primary work or principal place of business is on the island rather than in the mainland U.S.
- Closer Connection Test — You must demonstrate stronger personal and economic ties to Puerto Rico than to any other location, factoring in family, social, and business relationships.
Meeting these tests is more than a box-checking exercise. It requires consistent documentation, thoughtful planning of travel and living arrangements, and alignment between your day-to-day life and the legal definitions of residency.
2. Income Sourcing – Where Income Is Earned Matters
Even with bona fide residency, not all income is treated the same.
Puerto Rico and U.S. tax law distinguish between Puerto Rico-sourced and U.S.-sourced income. Under Section 933 of the U.S. Internal Revenue Code, bona fide residents may exclude their Puerto Rico-source income from U.S. federal tax, but income sourced outside Puerto Rico generally remains taxable by the U.S.
This distinction is critical for individuals with diverse income streams:
- Capital gains — Gains on assets acquired after establishing Puerto Rico residency generally qualify as Puerto Rico-source and may qualify for only a 4% tax rate, while assets held before relocating may still trigger U.S. tax depending on timing and sourcing rules.
- Dividends and interest — Income from Puerto Rico entities may be treated as Puerto Rico-sourced, but U.S.-based dividends often remain subject to U.S. tax.
Understanding and documenting the source of each type of income is not optional, it’s central to compliance.
3. Substance – Real Presence and Economic Engagement
Act 60 incentives are not rewards for nominal paperwork or superficial ties. They are designed to attract individuals whose economic and lifestyle footprint aligns with Puerto Rico’s long-term development goals.
Substance includes:
- Maintaining a real residence on the island
- Establishing meaningful financial, social, and professional ties to Puerto Rico
- Complying with annual reporting and documentation, such as the Exempt Annual Report to the Puerto Rico Department of Economic Development and Commerce (DDEC), and fulfilling related requirements like charitable contributions that some decrees mandate.
Without genuine substance, residency and sourcing tests may not hold up under scrutiny. Both Puerto Rico tax authorities and the IRS have increasingly focused on proper documentation and real economic presence when evaluating compliance claims.
Ongoing Compliance is Required for Benefits
Act 60 incentives offer meaningful opportunities, but they are anchored in ongoing compliance, not one-time qualification. To benefit, you must continuously align your residency, income sources, and economic engagement with the legal standards set by both Puerto Rico and U.S. tax law.
Understanding these three pillars — residency, sourcing, and substance — is not just prudent. It’s essential for anyone considering Act 60 as part of a long-term tax strategy.