Billionaires should beware of Puerto Rico

FORTUNE — John Paulson and other plutocrats should think twice before moving to Puerto Rico in search of a tax break. While the Caribbean Island’s recent push to lure wealthy individuals from the U.S. mainland seems like a great deal, there is no guarantee that the Puerto Rican government will be able to make good on their long-term promises.

The U.S. territory has a bevy of social and economic problems that appear to be getting worse by the day, making it an inhospitable place for a wealthy individual seeking safety and stability. Crime broke through record highs in the last few years and has started to spill into the wealthy neighborhoods of San Juan, the capital. The violence and economic malaise show little sign of abating. It’s a long way from the financial paradise the Puerto Rican government is trying so hard to portray it as.

The financial crisis has forced governments around the world to think of new and creative ways to generate and retain income. In the U.S., fiscal stimulus and money printing was the name of the game for the first few years. Now the government is slashing spending and raising taxes, much to the chagrin of just about everybody, but especially to the top 2% of U.S. taxpayers who are bearing the brunt of the tax hikes.

Indeed, the tax rate on long-term capital gains and dividends for the top 2% of earners jumped this year from 15%, where it had been for over a decade, to just under 24%. The wealthy also saw a boost in federal income taxes from 35% to 39.6%. This has made a lot of America’s top earners very upset, especially for big-time investors, like John Paulson. The hedge fund manager who made an estimated $15 billion betting against the housing bubble, along with a number of rich investors, is reportedly looking to move to Puerto Rico to avoid getting stuck with a high tax bill.

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Why Puerto Rico? Well, the island recently passed a law allowing new residents to pay zero tax on capital gains and zero tax on income derived from local businesses. This rate applies only to income and gains derived from investments made after the person has become a resident of the island and will last through the end of 2035. Income and gains that accrued before residency was established, but have yet to be taxed, such as paper gains made in a stock that has yet to be sold, will be subject to Puerto Rico’s normal 10% capital gains rate. For investments sold after 10 years, but before the end of 2035, the rate drops to 5%.

Being able to move investment earnings made in the past is probably what grabbed Paulson’s attention. He has apparently reinvested much of his winnings back into his fund, so he has not paid taxes on the bulk of his wealth. His investment performance hasn’t been so hot since the housing crisis, but he still has billions of dollars left floating in his fund that he can’t take out without receiving a big tax bill from Uncle Sam.

So to save a few billion dollars, Paulson could make the move down south to Puerto Rico. Becoming a resident of Puerto Rico and receiving this tax benefit involves filling out a simple form and living on the island for at least 183 days per calendar year. But unlike other tax avoidance schemes, Paulson and his family don’t have to renounce their U.S. citizenship to get the special tax break given Puerto Rico’s unique tax arrangement with the U.S.

There are worse fates than to be forced to live in Puerto Rico for half the year. But for millionaires and even billionaires, like Paulson, it may not be worth it. The political, economic, and social conditions down in Puerto Rico are extremely unstable and may not be the best bet in the tax game.

Politically, Puerto Rico is in a state of flux, which means its new investment law could be countered or revoked. There is a reason why Puerto Rico hasn’t tried this beggar-thy-neighbor kind of tax war with the U.S. in the past — it makes Washington angry. That’s a big deal given that Puerto Rico receives around $22 billion from the U.S. every year in the form of aid and subsidies. That makes up around a quarter of the island’s GDP. It could see some of that aid sliced off if it nails some big billionaire fish like Paulson.

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“The situation with Puerto Rico might draw more attention to how U.S. territories are treated under U.S. tax laws,” Sen. Chuck Grassley, the Republican from Iowa and member of the Joint Committee on Taxation, told Fortune. “Harmonizing the tax rules of the territories could be something to look at if Congress and the President undertake comprehensive tax reform. Or if Puerto Rico maintains a separate tax system, which could be conditioned on accepting certain rules to prevent tax evasion.”

It is not just Republicans who have their eye on Puerto Rico. A spokesman for Senator Max Baucus, the Democrat from Montana and Chairman of the Senate Finance Committee, said that the Puerto Rico issue is on the Senator’s radar, and he is looking into it as part of his efforts in comprehensive tax reform.

The U.S. government could bully Puerto Rico to harmonize its tax code by withholding funds, or it could do it by default by just making it the 51st state. While that might sound crazy, it is actually a real possibility. Puerto Ricans voted overwhelmingly to join the U.S. as a state in a non-binding referendum last November. President Obama says he supports the admission of Puerto Rico into the union as soon as possible. Congress needs to vote on its admission, which could theoretically occur at any time. The only thing standing in Puerto Rico’s way is partisan politics. Republicans aren’t too keen to allow in a new state that would be solidly Democratic blue. But with the party championing Marco Rubio, the young Hispanic Republican Senator from Florida — home to many Puerto Ricans, Republicans may come to see Puerto Rico as an asset and not a liberal liability in the 2016 election.

So the new law may eventually become null and void. If Paulson moves fast enough he may slip under the radar. But he would still have to live in Puerto Rico with his family for at least 183 days per year, which will undoubtedly be scrutinized by the U.S. government extensively to make sure he isn’t cheating. Life in San Juan isn’t as exciting as it is in New York, and the shopping pales in comparison. Indeed, San Juan and the rest of the island are heavy on the kitsch but low on the substance when it comes to entertainment options. The beach is amazing, but eventually, for a city boy like Paulson, the island could come to resemble a sort of paradise prison.

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And Puerto Rico is not all beaches and historic forts. Paulson must live amongst a population under economic and social terror. Forty-five percent of the population lives under the poverty line. The reduction of manufacturing subsidies by the U.S. government combined with the financial crisis has hit the island’s economy hard. Unemployment is up around 15%, nearly double that of the U.S., forcing Puerto Ricans to abandon the island in droves, especially the educated elite.

The poverty has forced many into the underground economy, most notably the drug trade. Puerto Rico is an excellent gateway into the U.S. market as planes taking off from the island bound for the mainland are considered domestic flights. Smuggling drugs on the island from places like Colombia has become child’s play, making Puerto Rico one of the deadliest crossroads in the never-ending War on Drugs. Murders on the island hit an all-time high in 2011 with 1,136 people killed. The murder rate of 31 per 100,000 people is six-and-a-half times higher than that of the U.S. and nearly a quarter more than that of Mexico.

It is not just drug smugglers getting killed; ordinary citizens, many of them professionals, have been killed in a rash of fatal burglaries, home invasions, muggings, and car jackings, which have their roots in the drug war. Muggings in the posh Condado neighborhood in San Juan, the area Paulson is reportedly looking into buying a property, are on the rise. NPR recently profiled one such mugging in a week-long special highlighting the troubles plaguing the island. The New York Times told the story of a banking executive who was shot three times in the neck while driving his Lexus in the summer of 2011.

A couple of high-profile murders seem to have pushed Puerto Rico over the edge. The first was the shooting death in November of three-time boxing champion Hector “Macho” Camacho while he was sitting in his car outside of a nightclub by unknown assailants. The second was the death of José Enrique Gomez in December. Gomez, a publicist, was robbed, beaten and doused with gasoline, and then set alight by four young men. The brutal and senseless killing shocked the nation because Gomez was robbed in a supposedly “safe” area and was not involved in the drug trade. Ricky Martin and other Puerto Rican celebrities — none of whom actually live in Puerto Rico anymore — took to social media outlets like Twitter and Facebook to protest the murder.

Crime happens everywhere, but the high murder rate in Puerto Rico is enough to send the toughest plutocrat back to the U.S. in short order. The new governor of Puerto Rico, Alejandro Garcia Padilla, activated the National Guard to patrol key areas of the country as his first order. The stepped-up presence could make a difference. While sending in the troops is usually frowned upon for routine patrols, it may be necessary to retain order given the ineptitude of the Puerto Rico police force. But the political risks combined with the crime seem to paint a picture that isn’t ready to bring in millionaires, let alone billionaires like Paulson.

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