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Analysis

Billion-dollar tax break could give Puerto Rico false hope again

By JOE LIGHT | Bloomberg News | Published: December 12, 2018

WASHINGTON (Tribune News Service) — One of the biggest breaks created by last year's tax law sits in Puerto Rico, a hurricane-ravaged island desperate for a recovery. But some residents fear tax history could repeat itself.

President Donald Trump's overhaul sets up "opportunity zones" in underdeveloped economic areas that try to lure investment with the promise of generous tax benefits. Almost all of Puerto Rico was deemed a zone, essentially creating a 3,500-square-mile tax haven that the island's governor hopes will bring more than $600 million in new investment.

As of now though, the designation is set to expire after 10 years. If that sounds familiar, it's because Puerto Rico has been through this before. A previous corporate tax break led to a pharmaceutical boom, but when it phased out in 2006, the island saw dozens of manufacturers flee the island – contributing to a fiscal crisis from which it's still recovering.

"Instead of leveraging that break to help local businesses stand on their own feet, we wasted it," said Carlos Serrano, a tax partner at Reichard & Escalera who works with the Puerto Rico Manufacturers Association.

Hurricane Maria exacerbated Puerto Rico's economic woes and devastated its infrastructure, causing an estimated $90 billion in damage.

To jaded economists who watched the boom and bust, the new law could just be more false hope – by giving tax breaks to wealthy real estate investors without fostering jobs-creating businesses.

"How do you build a plant that's going to produce something and then in 10 years pack up and leave?" says Zadia Feliciano, a professor at Queens College-City University of New York who has researched previous Puerto Rico tax breaks. Ten years "is not a long time for the kind of investment you have to make."

Puerto Rico has long used tax benefits to lure investment. New residents of Puerto Rico generally don't pay Puerto Rico taxes on passive income or federal income tax, spurring the creation of wealthy enclaves of mainlanders seeking the break. Hedge fund manager John Paulson in November at a conference said he was considering moving to Puerto Rico once his children leave for college.

The island used to have an even larger break for businesses. In the 1920s, Congress created a tax exemption for all income from non-U.S. sources as long as a company received at least 80 percent of its income from U.S. possessions such as Puerto Rico.

Revisions to the law in the 1970s and 1980s restricted it in a way that encouraged jobs-creating businesses, and the pharmaceutical industry created thousands of jobs on the island. But between 1995 and 2005, Congress phased out the benefit completely.

Feliciano's research, which compared Puerto Rico to U.S. states that didn't experience the change, estimates that the elimination of the benefit had the effect of cutting manufacturing wages by almost 17 percent and the number of manufacturing businesses by as much as 28 percent.

Unlike when it eliminated the benefit, which caught many manufacturers off guard, Congress created opportunity zones with a built-in expiration date. So instead of setting the island up for a crash once the zones disappear, the tax law might discourage long-term, jobs-creating investments in the first place, according to Feliciano.

Under the opportunity zone provision, investors can take capital gains from asset sales and plow them into funds that buy real estate or invest in businesses in opportunity zones. In turn, they can defer taxes until 2026 and potentially reduce what they owe by as much as 15 percent. If they hold the investment for at least 10 years, they can also avoid paying capital gains taxes on the fund's appreciation. The change is estimated to cost $1.6 billion over a decade.

The zones' expiration dates means that most investors will be focused on buying real estate instead of putting money into new businesses. Giovanni Mendez, a tax attorney in Puerto Rico, said he knows of at least eight funds that are buying up real estate on the island. A New York-based fund, which he declined to identify, has earmarked $100 million for opportunity zone investments in Puerto Rico.

"Commercial real estate is moving very fast," Mendez said. "There's sort of a frenzy because of this."

The Internal Revenue Service recently proposed regulations about opportunity zones, which could also make investments in startups more difficult since a certain percentage of the business' gross income has to come from within the zone. The rules also specify that even if a zone loses its designation after 10 years, investors can generally keep their tax benefits through 2047.

The zones were tucked into last year's tax revamp and were one of the rare features of the law with bipartisan support. Still, critics have said the provision was written so broadly that savvy investors and real estate developers could exploit it for projects they would have done anyway.

Treasury Secretary Steven Mnuchin earlier this year predicted the little-known break could attract as much as $100 billion in investments in total.

Puerto Rico Gov. Ricardo Rossello, who supports the island's zone designation, introduced legislation in November that's necessary to extend the capital gains tax breaks for investing in opportunity zones to Puerto Rico residents.

Matt Prober, a commercial real estate adviser and investor, said he and a team of other investors were motivated by the island's opportunity zone status to buy a 17,000-square-foot building in the capital city of San Juan that had been boarded up for about a decade. They bought it for $600,000 and plan to invest twice as much in construction costs, eventually featuring a restaurant and four floors of office space.

Prober said private equity investors from the U.S. for the past several years had been slowly buying and rehabilitating properties, but with the limited window for opportunity funds, he thinks the pace will quicken. His own team of investors has raised $25 million for a fund.

"I'm probably as optimistic as I've been for real estate in Puerto Rico in the last 10 years," Prober said, though he added that the short timeline for the break could limit its effectiveness.

"I hope the government of Puerto Rico won't just see this as the one and only way out," Prober said. "There are other things they need to do to spur on development."

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