How 2017 Tax Reform Affects Top-Bracket Taxable Investors

Active Tax Management

How 2017 Tax Reform Affects Top-Bracket Taxable Investors

January 18, 2018

While the recently enacted Tax Cuts and Jobs Act has appropriately generated a great deal of press coverage and analysis, not as much has been written on its impact on taxable ultra-high-net-worth (UHNW) investors. Many investors and advisors were appropriately concerned about the proposed requirement to use the FIFO (first-in, first-out) method for sale of securities, although that change did not make it into law. However, for many UHNW taxpayers, we believe the remaining impact could still potentially prove substantial, especially from the three following changes:

  1. The top ordinary rate will drop from 39.6% to 37.0%. This change will affect ordinary income and short-term capital gains.
  2. State income tax will no longer be deductible against regular federal liability. This means that investors in high-tax states may see a net increase in both the ordinary income/short-term rate and in the long-term capital gain rate, even after including the federal rate drop described above.
  3. Although the AMT (alternative minimum tax) has not changed all that much, the difference between AMT and regular taxes has changed dramatically. While the thresholds for phase-outs and exemptions have changed for the AMT, the really significant development is that some of the biggest AMT preference items (state taxes, property taxes, and miscellaneous deductions) are now no longer different between AMT and regular.

Table 1 details the changes for regular taxes and AMT, with rates shown in percentages and changes in percentage points (pp).

table 1

Table 2 shows the effect of these rate changes on UHNW taxpayers living in three states, one with the highest rate, one with a medium-size rate, and one with no state income taxes.

table 2

Table 2 shows some interesting effects, such as the fact that for California UHNW taxpayers, their all-in short rates will rise some at 3.2 percentage points, but their long-term rates will jump by much more, increasing by nearly 6 percentage points. That change reflects the disappearance of deductibility of state taxes, which hits the long-term rate the hardest, since the federal rate remains unaffected. The short-gain rate will increase less for UHNW California taxpayers due to the drop in the federal rate.

Missouri was not selected randomly but rather as one of the states with a 6.0% rate, which means that for UHNW investors, the drop in the top short-term rate will happen to offset exactly the loss of deductibility of state income taxes. In Texas, and other states without state income tax, UHNW investors will be paying a lower rate on short-term gains, with no change on long-term gains.

Turning to AMT, many tax experts have pointed out that the AMT rules themselves may not have changed all that much except for the levels for exemptions and phase-outs. However, the big change here instead lies in the comparison between the AMT and regular taxes. Since incremental AMT liability is determined by calculating the difference between liabilities under the two systems, many UHNW taxpayers will no longer be subject to AMT since the differences have shrunk so dramatically. To phrase it differently, the important difference in AMT is not that the AMT rules changed much but rather that the regular rules changed a lot and now look in many ways like the AMT. Thus, just because an UHNW taxpayer was in the AMT system in 2017 does mean it’s wise to assume the same taxpayer will remain subject to AMT in 2018.

Table 3 shows a hypothetical and extreme example of a taxpayer with income of 100 and an abnormally high level of AMT preference items that now are no different between AMT and regular. Under the Old columns, we can see that the highest tax liability would be 28 under AMT, higher than the 27 under regular. However, in 2018, state and property taxes will not be deductible under regular rates, which will cause the tax liability to rise to 37 and the taxpayer to flip to regular rates from AMT. The marginal tax rate effectively increases from 28% to 37% excluding any state tax or Net Investment Income Tax (NIIT, often called the Medicare tax).

table 3

Chart 1 shows graphically the numbers shown in Table 3, emphasizing that the gap in taxable income often drives net AMT liability.

chart 1

Table 4 shows the net effect of the recent tax changes on UHNW taxpayers who had been subject to the AMT because of the bigger “gap” but in 2018 may have to pay regular rates. Many UHNW taxpayers will still be subject to the AMT, but the situations where AMT differs dramatically will be less prevalent. Some preference items do remain, such as certain depreciation and incentive stock options, but some forecasters are predicting that far fewer UHNW clients will be subject to AMT.* For investors wondering about whether or not they may be subject to AMT in 2018, it may be worthwhile to check with their tax advisors, specifically asking, “If I’m still subject to AMT in 2018, which preference items will be triggering that treatment, since so many important ones like state taxes are no longer relevant?”

table 4

These changes we’ve described may not grab the same headlines as other very important parts of the 2017 tax reform, such as the drop in the corporate rate. However, they may affect in real ways UHNW investors, depending on their state of residence. For tax planning, any investor assuming AMT for 2018 should at least analyze the major change in the differences between AMT and regular taxable income rates. In addition, the change in state deductibility affects taxpayers quite differently depending on their state of residence.

*See, for example, “The Tax Cuts and Jobs Act,” a white paper published by UBS in December 2017, p. 3.

Additional Resources

Listen to Patrick Geddes, Chief Tax Economist, and Ran Leshem, CIO, discuss this topic:


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