The New 2026 Section 68 Itemized-Deduction Limitation: How the 2/37 Formula Works

If the Section 68 statutory computation places your 2026 taxable income in the 37% bracket, otherwise allowable itemized deductions can be reduced. The reduction is 2/37 of the lesser of (a) otherwise allowable itemized deductions or (b) the excess over the applicable 37%-bracket threshold after applying Section 68's prescribed taxable-income adjustment. Once that excess is at least as large as the deductions, the top-bracket benefit is approximately 35 cents rather than 37 cents per dollar.

This new rule is sometimes described informally as a revived Pease limitation because both versions occupy IRC Section 68. That shorthand is imprecise. OBBBA made the prior limitation's elimination permanent and enacted a different 2/37 limitation on the benefit of itemized deductions for taxpayers in the 37% bracket. The pre-2018 rule used AGI, a 3% formula, and an 80% ceiling; the 2026 rule does not.

I am writing this guide for NJ high earners specifically because the NJ angle is counterintuitive. NJ does not use federal itemized deductions on the NJ-1040, so the Pease limitation has zero direct impact on your NJ tax liability. But the federal impact is significant, especially for NJ taxpayers who itemize large SALT deductions (property taxes capped at $40,400 for 2026 under the OBBBA's expanded SALT cap) and mortgage interest.

Figures and statutory mechanics in this guide were last reviewed August 6, 2026 against IRC Section 68 and IRS 2026 inflation guidance.

In This Article

1. What the New Section 68 Limitation Is and Why It Is Called the "2/37 Rule"
2. How Pre-2018 Pease Differs From the 2026 Rule
3. 2026 Income Thresholds
4. The Math: How 37 Cents Becomes 35 Cents
5. What Deductions Are Affected
6. Worked Examples at $700K, $1M, and $2M
7. NJ Impact: Why Your State Return Is Unaffected
8. Interaction with Other OBBBA Changes
9. Planning Strategies
10. FAQ

What the New Section 68 Limitation Is and Why It Is Called the "2/37 Rule"

The historical Pease limitation was named after former Congressman Donald Pease. It applied before 2018 and was suspended for 2018-2025. Effective for 2026, OBBBA did not restore that old formula; it enacted the current 2/37 rule in Section 68.

The OBBBA version works differently from the original. The pre-TCJA Pease reduced total itemized deductions by 3% of the amount by which AGI exceeded the threshold (the "3% haircut"), with a maximum reduction of 80% of itemized deductions. The new version under the OBBBA replaces that formula with what practitioners are calling the "2/37 rule."

Under the 2/37 rule, the deduction reduction is 2/37 (approximately 5.41%) of the statutory lesser amount, not automatically 2/37 of all deductions as soon as income crosses the threshold. In the fully phased-in case, the top-bracket benefit is approximately 35 cents instead of 37 cents per dollar. During the phase-in, the result is between those amounts.

The '2/37' comes from the worksheet mechanics: allowable itemized deductions are reduced by 2/37 of the lesser applicable amount. In an isolated, fully phased-in illustration where the affected deduction offsets income at 37%, the modeled regular federal income-tax reduction is about 35 cents rather than 37 cents per affected dollar. That is not a complete-return result.

How Pre-2018 Pease Differs From the 2026 Rule

Pre-TCJA Pease (1991-2017):

• Reduced total itemized deductions by 3% of AGI above the threshold
• Maximum reduction: 80% of affected itemized deductions
• Threshold adjusted annually for inflation
• Example: AGI $500,000 over threshold → deductions reduced by $15,000 (3% x $500,000)

New Section 68 rule (2026+):

• Reduces your total itemized deductions by 2/37 of the lesser of (a) total itemized deductions or (b) taxable income above the 37%-bracket threshold - the smaller deduction total is what produces the smaller tax benefit
• Applies once taxable income (before itemized deductions) exceeds the applicable threshold
• Does not use the old 80% ceiling; the 2/37 lesser-of formula supplies its own bound
• The effective top rate for deductions becomes 35% instead of 37%

The formulas are structurally different. The current reduction can never exceed 2/37 of otherwise allowable itemized deductions, and it phases in based on the second limb of the lesser-of test. Calling it 'Pease' should not be taken to import the former AGI or 80%-ceiling mechanics.

2026 Income Thresholds

For an individual return, the Section 68 computation uses the following 2026 thresholds:

Estates and nongrantor trusts require a separate fiduciary-return analysis. Through Section 641(b), the same Section 68 2/37 lesser-of formula applies to the separately taxed portion of an estate or nongrantor trust, but Section 1(e)'s 37% bracket begins above $16,000 for 2026, not at an individual filing-status threshold. The Joint Committee on Taxation explains that the fiduciary itemized-deduction base includes the Section 642(b) personal exemption and the beneficiary-distribution deductions under Sections 651 and 661, among other deductions. A grantor-trust portion is instead attributed to its deemed owner under Section 671. Fiduciary accounting income, the Section 642(c) charitable deduction, and other Subchapter J rules can change the base and who bears the income, so the individual examples below must not be reused for a Form 1041 computation.

These thresholds correspond to the start of the 37% federal rate bracket for 2026. During the phase-in, an additional dollar in the statutory excess can disallow about 2/37 of a dollar of deductions, which can add about two cents of regular federal income tax at the 37% rate. This is a marginal effect, not a separate tax bracket.

Important - this is NOT a cliff, and it keys off taxable income, not AGI. Under the OBBBA's revised Section 68, itemized deductions are reduced by 2/37 of the LESSER of (a) your total itemized deductions or (b) the amount by which your taxable income (computed before itemized deductions) exceeds the 37%-bracket threshold. Just over the threshold, limb (b) is small, so the limitation phases in gradually - $1 of extra income can reduce the deduction value by about two cents in the isolated 37%-rate arithmetic, not by 2/37 of everything. The 35-cent modeled component applies only after the excess reaches the otherwise allowable deduction amount and only to the stated rate assumption.

The Math: How 37 Cents Becomes 35 Cents

For this arithmetic illustration only, assume a full $100,000 deduction offsets income otherwise taxed at 37%. Multiplication produces a modeled $37,000 regular federal income-tax reduction before Section 68 ($100,000 x 37%); it is not a complete-return, payment, refund, or planning result.

After applying the Section 68 2/37 reduction within those assumptions:

• Reduction: $100,000 x (2/37) = $5,405
• Effective deduction value: $100,000 - $5,405 = $94,595
• Modeled regular federal income-tax reduction after Section 68: $94,595 x 37% = $35,000
• Alternatively: $100,000 x (35/37) x 37% = $100,000 x 35% = $35,000

In this isolated, fully phased-in illustration, each affected dollar produces a modeled 35-cent regular federal income-tax reduction rather than 37 cents. The statement is not a complete-return result and does not apply to deductions outside the 37% bracket or while the lesser-of formula is still phasing in.

What the isolated arithmetic shows: Section 68 reduces the otherwise allowable itemized-deduction amount under its lesser-of formula. When the fully phased-in affected amount offsets income at 37%, the modeled regular federal income-tax reduction is 35 cents rather than 37 cents per affected dollar. The complete return can differ.

If the full deduction amount is the lesser limb and would otherwise offset income at 37%, the isolated arithmetic produces a modeled regular federal income-tax difference of about $4,000 on $200,000 of deductions and about $10,000 on $500,000. Those components are not complete-return or universal outcomes.

Technical note: The 35-cents-versus-37-cents illustration assumes the affected amount offsets income at the 37% rate. Deductions that cross brackets and the rest of the return require the statutory computation; the simplified component must not be treated as a taxpayer's actual tax reduction, balance, refund, or planning outcome.

What Deductions Are Affected

Section 68 applies after other limitations have determined the otherwise allowable itemized-deduction amount. The following common Schedule A items can therefore enter its aggregate base:

Affected deductions:

• State and local taxes (SALT) - capped at $40,400 for 2026 under the OBBBA
• Mortgage interest (on acquisition debt up to $750,000)
• Charitable contributions
• Medical expenses (exceeding 7.5% of AGI)
• Casualty and theft losses (federally declared disasters only)

Not affected by Pease:

• The standard deduction for an individual (the Section 68 base is itemized deductions, while estates and trusts do not receive an individual standard deduction)
• Above-the-line deductions (Schedule 1 and Schedule 1-A deductions are not itemized deductions)
• Tax credits (credits are dollar-for-dollar, not subject to Pease)

Fiduciary-return deduction base: Section 68 is not limited to deductions reported on an individual's Schedule A. For a separately taxed estate or nongrantor trust, Sections 641(b) and 63(d) make the relevant Form 1041 deductions part of the Section 68 computation, including the Section 642(b), 651, and 661 deductions identified by the Joint Committee on Taxation. That base and the $16,000 Section 1(e) threshold make the fiduciary calculation materially different from the individual examples here.

The SALT cap interaction: The 2026 federal SALT cap is $40,400 before its income-based phase-down. If a full $40,400 survives that separate limitation, falls within the fully phased-in Section 68 lesser amount, and offsets income otherwise taxed at 37%, its illustrative federal benefit is $14,140 rather than $14,948. Actual results depend on both statutory limitations and the taxpayer's brackets.

Worked Examples at $700K, $1M, and $2M

New for 2026 - coordinate the charitable floor and carryover rules. An individual itemizer generally deducts otherwise allowable charitable contributions only to the extent they exceed 0.5% of contribution base. Contribution type, property, donee, holding period, substantiation, valuation, and the applicable percentage limitation must be tested as well. An amount disallowed solely by the 0.5% floor does not automatically disappear forever: it enters a charitable carryover only to the limited extent the year's contributions also exceed the applicable percentage limitation. The examples below isolate Section 68 and assume the displayed charitable amount is otherwise allowable after those rules; they do not determine a donor's floor, carryover, or tax result.

Example 1: Single Filer, $700,000 taxable income (pre-itemized)

• Taxable income before itemized deductions: $700,000 (above the $640,600 threshold by $59,400)
• Itemized deductions: $75,400 (SALT $40,400 + mortgage interest $25,000 + charitable $10,000)
• Lesser-of test: lesser of (a) $75,400 deductions or (b) $59,400 excess = $59,400 - this taxpayer is still in the phase-in zone
• Reduction: 2/37 x $59,400 = $3,211 of deductions disallowed; in the isolated 37%-rate arithmetic, the modeled regular federal income-tax reduction changes from $27,898 to about $26,710
• Modeled Section 68 regular-tax difference: about $1,188 (2% of the $59,400 lesser amount)
• New Jersey tax is not calculated in this federal illustration; Section 68 does not create a corresponding Schedule A reduction on the NJ-1040

Example 2: Married Filing Jointly, $1,000,000 taxable income (pre-itemized)

• Taxable income before itemized deductions: $1,000,000 (above the $768,700 threshold by $231,300 - more than their deductions, so the full 2/37 applies)
• Itemized deductions: $120,400 (SALT $40,400 + mortgage interest $45,000 + charitable $35,000)
• Modeled component before Section 68: $120,400 x 37% = $44,548
• Modeled component after Section 68: $120,400 x 35% = $42,140
• Modeled Section 68 regular-tax difference: about $2,408
• Within the same isolated assumptions, the $35,000 charitable amount contributes a $12,950 component before Section 68 and a $12,250 component after it; this does not value the gift or predict the return result
• New Jersey tax is not calculated in this federal illustration; Section 68 does not create a corresponding Schedule A reduction on the NJ-1040

Example 3: Married Filing Jointly, $2,000,000 taxable income (pre-itemized)

• Taxable income before itemized deductions: $2,000,000 (well above the $768,700 threshold - full 2/37 applies)
• Itemized deductions: $250,400 (SALT $40,400 + mortgage interest $40,000 + charitable $170,000)
• Modeled component before Section 68: $250,400 x 37% = $92,648
• Modeled component after Section 68: $250,400 x 35% = $87,640
• Modeled Section 68 regular-tax difference: about $5,008
• This isolated arithmetic is not an IRS payment, balance-due, refund, or complete-return result
• New Jersey tax is not calculated in this federal illustration; Section 68 does not create a corresponding Schedule A reduction on the NJ-1040

Summary Table

NJ Impact: Why the Federal Rule Does Not Directly Carry to the NJ-1040

Section 68 does not directly reduce a deduction on the NJ-1040. New Jersey does not import federal Schedule A itemized deductions into its gross-income-tax calculation. Federal tax changes can still affect cash flow, estimated payments, and planning assumptions, so 'no direct NJ-1040 adjustment' is more precise than saying the rule has no NJ-related consequence.

NJ does not allow a SALT deduction, a mortgage interest deduction, or a charitable deduction on the NJ-1040 for individuals. NJ property tax benefits are delivered through separate programs (ANCHOR, Senior Freeze/Property Tax Reimbursement) rather than through the income tax return. NJ charitable contributions are not deductible for NJ Gross Income Tax purposes.

What this means practically: In the worked federal example, the Section 68 adjustment is computed on the federal return. It does not flow through as a corresponding Schedule A reduction on the NJ-1040, which uses New Jersey's own income categories, deductions, exclusions, and credits.

For a complete analysis of which federal tax provisions NJ follows, see my NJ OBBBA Conformity Guide.

Interaction with Other OBBBA Changes

The new Section 68 limitation does not operate in isolation. Several other OBBBA provisions interact with it for 2026:

SALT cap increase ($10,000 → $40,000 for 2025, $40,400 for 2026): The higher SALT cap means more NJ taxpayers will itemize (high property taxes now deductible up to $40,400 in 2026). More itemizers means more people affected by Pease. A NJ couple paying $35,000 in property taxes could not deduct it all under the $10,000 TCJA cap. Now they can - but Pease reduces the value by 2/37. The net benefit is still strongly positive (far better to deduct $35,000 at 35% than $10,000 at 37%), but Pease clips the edge. For more on the SALT cap, see my NJ BAIT vs. SALT Cap guide.

Charitable deduction: A contribution is first tested under the charitable-deduction rules, including the 0.5%-of-AGI floor, percentage limits, substantiation, valuation, and carryforward rules. In the isolated fully phased-in illustration, a $100,000 otherwise allowable amount that offsets income at 37% contributes a modeled $35,000 regular federal income-tax reduction after Section 68 rather than $37,000 before it. Those figures do not value the gift, determine its after-tax cost, or predict the complete return.

Mortgage interest: Interest must first satisfy Section 163 and its acquisition-debt and tracing rules. If $30,000 is otherwise allowable, is included in a fully phased-in Section 68 lesser amount, and offsets income at 37%, the illustrative reduction allocable to that amount is about $1,622, producing about $600 of additional federal tax. Section 68 does not make otherwise nondeductible interest deductible.

The double hit for NJ filers: For 2026 non-MFS taxpayers, the SALT cap phases down starting at $505K MAGI to a $10,000 floor; MFS taxpayers use a $252,500 threshold and $5,000 floor. Section 68 can then reduce the value of the itemized deductions that remain.

AMT interaction: The Pease limitation is a regular tax provision. It does not apply for Alternative Minimum Tax purposes. However, since AMT has its own limitations on itemized deductions (no SALT deduction in AMT), the interaction is complex. Taxpayers subject to AMT may find that Pease has less practical impact because AMT already limits their deductions more aggressively.

Planning Strategies

Income Timing Around the Threshold

Section 68 phases in rather than creating a cliff. Each additional dollar in the statutory excess can disallow about 2/37 of a dollar of deductions until the excess reaches the otherwise allowable deduction total. Income, deduction, and transaction timing can have broader tax and non-tax effects; this guide explains the computation and does not recommend a transaction or promise that timing alone will avoid the limitation.

Charitable Giving Strategy: Bunching and DAFs

A donor-advised fund can permit an irrevocable charitable contribution in one year while recommendations about later grants occur separately. Whether bunching changes the allowable deduction or after-tax result depends on charitable intent, AGI, itemization, the 0.5%-of-AGI floor, contribution ceilings, property valuation, substantiation, carryforwards, cash needs, and the complete return. Section 68 may reduce the marginal federal tax value of an otherwise allowable deduction; it does not make a DAF or bunching preferable for every donor.

Roth Conversion Considerations

If you are planning Roth conversions, the conversion income pushes your AGI higher. Once above the Pease threshold, the effective cost of conversion increases slightly (your itemized deductions are worth less). Factor the Pease cost into your Roth conversion analysis.

NJ BAIT Election

For NJ business owners, the NJ Business Alternative Income Tax (BAIT) election allows pass-through entity taxes to be deducted at the entity level, bypassing the SALT cap. Because BAIT reduces the SALT amount on your personal Schedule A, it indirectly reduces the Pease impact (less Schedule A deductions = less Pease cost). However, the primary benefit of BAIT is the SALT cap workaround, not Pease mitigation. For more on this planning tool, see my NJ BAIT vs. SALT Cap guide.

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Related reading: OBBBA Tax Changes for NJ Filers | NJ OBBBA Conformity Guide | NJ BAIT vs. SALT Cap | Year-End Tax Moves for NJ | Tax Resources

Circular 230 Disclosure: This content is for informational purposes only and does not constitute tax advice. Written tax advice from a Circular 230 practitioner is governed by 31 C.F.R. §10.37; Treasury’s 2014 final regulations eliminated the former “covered opinion” rules and their mandatory disclaimer legend, so no such legend appears here. Tax laws change frequently; consult a licensed CPA about your specific facts.