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OBBBA 2/37ths Rule: “Hidden” Tax Increase on High Earners

OBBBA 2/37ths Rule: “Hidden” Tax Increase on High Earners

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    High income taxpayers face a subtle but meaningful increase in their effective tax burden under the One Big Beautiful Bill Act (OBBBA). One of the most overlooked provisions is the 2/37ths limitation, which reduces the value of itemized deductions and increases overall tax liability. While the legislation expanded certain deductions, it also introduced new complexity that requires careful planning.

    Understanding the OBBBA 2/37ths Limitation

    Under this limitation, a taxpayer’s total itemized deductions are reduced by 2/37ths of the lesser of:

    • the total value of all itemized deductions claimed; or
    • the amount by which taxable income with all itemized deductions added back exceeds the beginning income amount for the top 37% marginal tax bracket.

    For 2026, the 37% bracket begins at $640,600 of taxable income for unmarried individuals and $768,700 for married couples filing jointly.

    The effect of this limitation is that taxpayers in 37% bracket, the top tax bracket, only get a 35% benefit when itemizing deductions. Sound complicated? Here’s how it works.

    Example: A married couple with $1,000,000 in taxable income and $100,000 of itemized deductions would have their itemized deductions reduced by 2/37ths of $100,000, or $5,405. With a marginal tax rate of 37%, the couple would pay an additional $2,000 of income taxes.

    Note that taxpayers with combined taxable income and itemized deductions below the top bracket are not subject to this reduction.

    Comparison to the Pease Limitation

    This overall limit on itemized deductions is similar to the Pease limitation that was in effect off and on during the 1990s, early 2000s, and up until 2017, when it was repealed by the Tax Cuts and Jobs Act (TCJA). That limit was complex, too, reducing the value of a taxpayer’s itemized deductions by 3% for taxable income above a threshold, although a taxpayer’s itemized deductions did not go below 80%. Effectively, the 2/37ths limit operates as the reinstated Pease limit.

    Purpose of Limitation

    The reintroduction of a deduction limitation reflects policy concerns around the distributional effects of most tax breaks in the 2025 Act. Itemized deductions disproportionately benefit higher income taxpayers, both because they are more likely to itemize and because deductions are more valuable at higher marginal tax rates.

    For example, the benefit of a tax deduction is the amount of the tax deduction multiplied by the taxpayer’s marginal tax rate. If a taxpayer is in the 20% bracket, a $1,000 deduction is worth $200. If a taxpayer’s marginal rate is 37%, the value of a $1,000 deduction is $370. According to the Congressional Research Service (The Tax Policy Center), 43% of the tax savings from itemized deductions go to the top 1% of income-earners, and 87% goes to the top 20%. Shaving off 2% of the benefit of itemized deductions targets the top 1% of taxpayers based on income.

    Interaction with the SALT Deduction Cap

    The 2/37ths calculation kicks in after specific limitations on the various itemized deductions have been applied. The most significant effect of this rule is for those bumping up against the state and local tax (SALT) deduction.

    The OBBBA increased the SALT deduction to $40,000, effective in 2025, with a 1% increase each year through 2029. The limit for 2026 is $40,400 (Note that the $10,000 TCJA limit returns in 2030 without further action by Congress). The SALT deduction phases down to $10,000 when a taxpayer’s modified adjusted gross income reaches $600,000.

    The new itemized deduction limit reduces 37%-bracket taxpayers’ SALT deduction to $38,216. Thus, the effect of the SALT limitation and the 2/37ths rule is to put two different limitations on SALT deductions, which is one of the three most important itemized deductions for high income earners. The other two are the mortgage interest deduction and the charitable contribution deduction.

    Planning Strategies for Itemized Deductions

    Given this new limitation on itemized deductions, adopting a strategy for itemizing the big three—mortgage interest, SALT and charitable deductions—is more important than ever. There are ways to delay or accelerate expenditures, particularly charitable deductions, which can help you avoid the worst of the 2/37ths rule. Consult your Frazier & Deeter tax advisor to guide you through this process.

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