Section 68 Is Back: The Stealth Tax Increase That Caps Your Itemized Deductions at 35 Cents

If your income exceeds $640,600 (single) or $768,700 (married filing jointly) in 2026, the tax benefit of every dollar you claim in itemized deductions just dropped from 37 cents to approximately 35 cents. This is the revived Pease limitation under IRC Section 68, and most high earners will not notice it until they see the math on their return. It is not a limit on what you can deduct — it is a limit on what those deductions are worth.

The Pease limitation is sometimes called the "stealth tax increase" because it does not appear as a separate line item. It operates by reducing the effective value of itemized deductions for taxpayers above the income threshold. The Tax Cuts and Jobs Act (TCJA) suspended Pease from 2018 through 2025. The One Big Beautiful Bill Act (OBBBA) brought it back for 2026, but in a different form than the pre-TCJA version.

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 $40,000 under the OBBBA's expanded SALT cap) and mortgage interest.

Every number in this guide is current as of March 2026.

In this guide:

1. What the Pease Limitation Is and Why It Is Called the "2/37 Rule"
2. How the Old Pease Worked vs. How the New Version Works
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 Pease Limitation Is and Why It Is Called the "2/37 Rule"

The Pease limitation is named after former Congressman Donald Pease, who authored the original provision in the Omnibus Budget Reconciliation Act of 1990. It was part of the tax code as IRC Section 68 from 1991 through 2017, then suspended by the TCJA for 2018-2025. The OBBBA revived it effective January 1, 2026.

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, for taxpayers with AGI above the threshold, the tax benefit of itemized deductions is reduced by 2/37 (approximately 5.41%) of the deduction amount. In practical terms, this means your itemized deductions are worth 35/37 of what they would otherwise be worth. Instead of saving 37 cents per dollar of deductions at the top marginal rate, you save approximately 35 cents.

The "2/37" comes from the mechanical operation: the provision effectively limits the rate at which itemized deductions reduce taxable income from 37% to approximately 35% for taxpayers in the top bracket. The 2-cent reduction per dollar is the "stealth" part — it does not reduce the deduction itself, it reduces the tax benefit.

How the Old Pease Worked vs. How the New Version Works

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)

OBBBA Pease (2026+):

• Reduces the tax benefit (not the deduction amount) by 2/37 for all itemized deductions
• Applies once AGI exceeds the applicable threshold
• No maximum reduction (the 80% floor no longer applies)
• The effective top rate for deductions becomes 35% instead of 37%

The OBBBA version is simpler but potentially more impactful for very high earners. Under the old Pease, the maximum deduction reduction was capped at 80%. Under the new version, every dollar of itemized deductions above the threshold is affected with no cap.

2026 Income Thresholds

The Pease limitation applies when your adjusted gross income (AGI) exceeds the following thresholds for 2026:

These thresholds correspond to the start of the 37% federal tax bracket for 2026. This is by design — the Pease limitation effectively creates a "shadow bracket" above 37% for taxpayers who itemize.

Important: The limitation applies once your AGI exceeds the threshold by any amount. There is no gradual phase-in. If your AGI is $640,601 (single), the 2/37 rule applies to all of your itemized deductions. If your AGI is $640,599, it does not apply at all. This cliff effect makes income timing around the threshold valuable.

The Math: How 37 Cents Becomes 35 Cents

Without Pease, a taxpayer in the 37% bracket who claims $100,000 in itemized deductions saves $37,000 in federal tax ($100,000 x 37%).

With Pease (the 2/37 rule), the effective benefit of those deductions is reduced by 2/37:

• Reduction: $100,000 x (2/37) = $5,405
• Effective deduction value: $100,000 - $5,405 = $94,595
• Tax savings: $94,595 x 37% = $35,000
• Alternatively: $100,000 x (35/37) x 37% = $100,000 x 35% = $35,000

The net effect: every dollar of itemized deductions saves 35 cents instead of 37 cents. The 2-cent-per-dollar reduction is the Pease limitation in action.

For a taxpayer with $200,000 in itemized deductions, the Pease limitation costs $4,000 ($200,000 x 2 cents). For $500,000 in deductions, it costs $10,000. The dollar impact scales linearly with the size of your deductions.

Technical note: The 2/37 reduction applies to the deduction benefit at the 37% rate. For deductions that would otherwise be taxed at lower marginal rates (if your income straddles brackets), the calculation is more complex. In practice, for most taxpayers above the Pease threshold, the majority of their itemized deduction benefit is at the 37% rate, so the 35-cents-per-dollar approximation is accurate.

What Deductions Are Affected

The Pease limitation applies to nearly all itemized deductions on Schedule A:

Affected deductions:

• State and local taxes (SALT) — capped at $40,000 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 (Pease only applies to itemizers)
• 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)

The SALT cap interaction: The OBBBA raised the SALT deduction cap from $10,000 to $40,000 for 2026. This is a significant benefit for NJ taxpayers with high property taxes. However, the Pease limitation reduces the value of that $40,000 SALT deduction from $14,800 (37% x $40,000) to $14,000 (35% x $40,000) — a $800 difference. The SALT cap expansion giveth, and Pease taketh away (a little).

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

Example 1: Single Filer, $700,000 AGI

• AGI: $700,000 (above $640,600 threshold)
• Itemized deductions: $75,000 (SALT $40,000 + mortgage interest $25,000 + charitable $10,000)
• Without Pease: Tax benefit = $75,000 x 37% = $27,750
• With Pease (2/37 rule): Tax benefit = $75,000 x 35/37 x 37% = $75,000 x 35% = $26,250
• Pease cost: $1,500
• Effective deduction rate: 35% instead of 37%
• NJ impact: $0 (NJ does not use federal itemized deductions)

Example 2: Married Filing Jointly, $1,000,000 AGI

• AGI: $1,000,000 (above $768,700 threshold)
• Itemized deductions: $120,000 (SALT $40,000 + mortgage interest $45,000 + charitable $35,000)
• Without Pease: Tax benefit = $120,000 x 37% = $44,400
• With Pease (2/37 rule): Tax benefit = $120,000 x 35% = $42,000
• Pease cost: $2,400
• The couple loses $2,400 in federal tax savings due to the Pease limitation
• If they had donated the same $35,000 to charity expecting a $12,950 tax benefit, the actual benefit is $12,250 — a $700 reduction on the charitable deduction alone
• NJ impact: $0

Example 3: Married Filing Jointly, $2,000,000 AGI

• AGI: $2,000,000 (well above $768,700 threshold)
• Itemized deductions: $250,000 (SALT $40,000 + mortgage interest $40,000 + charitable $170,000)
• Without Pease: Tax benefit = $250,000 x 37% = $92,500
• With Pease (2/37 rule): Tax benefit = $250,000 x 35% = $87,500
• Pease cost: $5,000
• This couple writes a check to the IRS for $5,000 more than they would without Pease
• The effective marginal rate on income above the threshold is 37% + the Pease effect = approximately 39% when considering the reduced deduction benefit
• NJ impact: $0

Summary Table

NJ Impact: Why Your State Return Is Unaffected

The Pease limitation has zero impact on your NJ-1040. This is because New Jersey does not use federal itemized deductions. NJ calculates taxable income starting with NJ gross income (which differs from federal AGI) and applies its own deductions and exemptions — none of which reference Schedule A or IRC Section 68.

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: A NJ resident with $1,000,000 AGI and $120,000 in itemized deductions sees the $2,400 Pease cost on their federal return only. Their NJ-1040 is completely unaffected by Section 68. The NJ tax calculation proceeds as if Pease does not exist — because for NJ purposes, it does not.

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

Interaction with Other OBBBA Changes

The Pease limitation does not exist in isolation. Several other OBBBA provisions interact with it for 2026:

SALT cap increase ($10,000 → $40,000): The higher SALT cap means more NJ taxpayers will itemize (high property taxes now fully deductible up to $40,000). 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: For philanthropic NJ residents, Pease reduces the tax benefit of charitable contributions from 37% to 35%. A $100,000 donation to a NJ hospital saves $35,000 in federal tax instead of $37,000. The donation may still be the right decision, but the after-tax cost is $65,000 instead of $63,000.

Mortgage interest: NJ has among the highest home prices in the nation. Many NJ homeowners have mortgage balances approaching the $750,000 acquisition debt limit. The interest on those mortgages is fully deductible on Schedule A but subject to the Pease reduction. A homeowner paying $30,000 in mortgage interest loses $1,622 in tax benefit due to Pease ($30,000 x 2/37).

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

Because Pease applies as a cliff (fully on or fully off based on AGI), taxpayers near the threshold ($640,600 single / $768,700 MFJ) can benefit from timing income. Deferring a bonus, accelerating a deductible expense, or timing capital gains to keep AGI below the threshold eliminates Pease entirely. The value of staying below the threshold equals 2/37 of your total itemized deductions.

Charitable Giving Strategy: Bunching and DAFs

Donor-Advised Funds (DAFs) allow you to "bunch" multiple years of charitable contributions into one year. In a year where your AGI will exceed the Pease threshold regardless (you cannot avoid it), bunching charitable contributions maximizes the deduction — even at the reduced 35% rate, it is better than not deducting at all. In the off year, take the standard deduction. This strategy works regardless of Pease but becomes more valuable when Pease reduces the per-dollar benefit.

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.

Frequently Asked Questions