OBBBA 2/37 Rule: How the New Itemized Deduction Cap Affects High-Earning Clients

The One Big Beautiful Bill Act (H.R. 1, enacted 2025) introduced a stealth limitation that will surprise many high-income clients who itemize: beginning in 2026, taxpayers whose income reaches the 37% bracket cannot deduct each dollar of itemized deductions at their full marginal rate. Instead, the benefit is capped at effectively 35 cents per dollar. The mechanics derive from a formula requiring those taxpayers to reduce their total itemized deductions by 2/37 of the amount subject to the 37% rate — the "2/37 rule." For a client with $1 million in taxable income and $200,000 in itemized deductions, the actual tax benefit shrinks materially and the planning calculus changes for SALT, mortgage interest, charitable giving, and medical expenses alike. CPAs advising high-earners need to model this limitation before year-end 2025 — the last year it does not apply — and build a multi-year strategy around it.

Who the 2/37 Rule Affects

The limitation applies to taxpayers in the 37% marginal tax bracket — the top bracket under the OBBBA, which permanently retained TCJA rate structure. The 2026 thresholds (adjusted for inflation from the OBBBA's TCJA baseline) are approximately:

The IRS will publish final 2026 bracket thresholds in a revenue procedure in late 2025 or early 2026 (consistent with the pattern established by Rev. Proc. 2024-40 for 2025 amounts). The 2025 thresholds — $626,350 single / $751,600 MFJ — are the current reference baseline.

Taxpayers whose income falls below these thresholds are unaffected. The limitation does not phase in gradually; it applies to the portion of taxable income that exceeds the 37% bracket entry point.

How the 2/37 Calculation Works

The 2/37 rule, codified under the OBBBA's amendments to IRC §68, reduces the taxpayer's total itemized deductions by:

Reduction = 2/37 × the lesser of:

• Total itemized deductions, OR
• Taxable income (before itemized deductions) that falls within the 37% bracket — i.e., income above the bracket entry point

The practical effect is that for every dollar of itemized deductions, the benefit is worth only 35 cents in tax savings instead of 37 cents:

• Normal 37% benefit: 37 cents per deduction dollar
• 2/37 clawback: 2 cents per deduction dollar (2/37 × $0.37 ≈ $0.02)
• Net benefit: 35 cents per deduction dollar

Example — Single filer, $800,000 taxable income, $150,000 in itemized deductions:

The taxpayer has $800,000 − $640,000 = $160,000 in the 37% bracket. The lesser of $150,000 (itemized deductions) and $160,000 (37% bracket income) is $150,000.

Reduction = 2/37 × $150,000 = $8,108

Effective itemized deductions = $150,000 − $8,108 = $141,892

Tax cost of the limitation = $8,108 × 37% = $2,999 in additional tax

Example — MFJ couple, $1,200,000 taxable income, $250,000 in itemized deductions:

37% bracket income = $1,200,000 − $768,000 = $432,000. Lesser of $250,000 and $432,000 is $250,000.

Reduction = 2/37 × $250,000 = $13,514

Additional tax = $13,514 × 37% = $5,000

The limitation is capped by the lesser-of test: it cannot reduce deductions by more than the amount that falls within the 37% bracket, and it cannot create a deduction reduction greater than total itemized deductions.

Which Deductions the 2/37 Rule Hits

The limitation applies to the total of all itemized deductions under IRC §63(d), meaning every category is affected proportionally:

State and Local Taxes (SALT): The OBBBA raised the SALT cap to $40,000 (phasing out above $500,000 MAGI) through 2029. For clients already limited by the SALT cap, the 2/37 rule further reduces the effective benefit of whatever SALT they do deduct. See our SALT cap planning guide for the full phase-out mechanics.

Mortgage Interest: Clients with large acquisition indebtedness on high-value homes already operate under the $750,000 debt limit (locked in permanently under OBBBA). The 2/37 rule reduces the after-tax value of that interest by approximately $0.02 per dollar.

Charitable Contributions: OBBBA simultaneously introduced a separate limitation on charitable deductions — a 0.5% AGI floor before any deduction is allowed, plus a 35% benefit cap for 37% bracket taxpayers. Charitable deductions face a double limitation: the 0.5% AGI floor reduces the deductible amount, and the 2/37 rule then reduces the tax value of whatever remains. See our companion piece on charitable giving strategies under OBBBA for specific workarounds.

Medical Expenses: The 7.5% AGI floor already limits most high-earners from claiming medical deductions. The 2/37 rule applies to whatever medical deductions clear that hurdle.

Investment Interest Expense: For clients holding leveraged investment portfolios, this deduction (limited to net investment income) also falls within the 2/37 reduction.

Planning Strategies

1. Model Whether Itemizing Still Beats the Standard Deduction

The 2026 OBBBA-enhanced standard deduction is $16,000 (single) / $32,000 (MFJ). After the 2/37 reduction, the break-even for itemizing shifts upward. A MFJ client with $50,000 in SALT, $30,000 in mortgage interest, and $10,000 in charitable giving has $90,000 in gross itemized deductions — but after the 2/37 reduction, their effective deduction may be closer to $84,000. Run the calculation before assuming itemizing is still superior.

2. Manage Income to Stay Below the 37% Bracket Threshold

The 2/37 rule only applies to income within the 37% bracket. Strategies that move income below the threshold eliminate or reduce the limitation:

• Maximize pre-tax retirement plan contributions. For solo 401(k) participants, maximizing employer contributions, or for W-2 employees maximizing the $23,500 (2026) 401(k) deferral, reduces taxable income directly. The mega backdoor Roth strategy adds after-tax contributions that do not reduce current-year taxable income but can be relevant for long-term rate arbitrage planning.
• Defer income where feasible. If a client controls the timing of year-end bonuses, consulting income, or S-Corp distributions, pushing income below the 37% threshold eliminates the 2/37 reduction on the full itemized deduction base.
• Harvest capital losses. Clients with unrealized capital losses in taxable accounts can harvest them to offset gains that would otherwise push income into the 37% bracket.
• Consider a Roth conversion timing shift. Clients planning Roth conversions should recalculate whether a conversion that pushes income into the 37% bracket now also reduces the value of their itemized deductions, increasing the effective cost of the conversion. See the Roth IRA conversion guide for the full modeling framework.

3. Accelerate Deductions Into 2025

Because the 2/37 rule does not take effect until 2026, the highest-value planning move for many clients is accelerating itemized deductions into 2025:

• Charitable contributions made in 2025 are not subject to the 0.5% AGI floor, the 35% cap, or the 2/37 reduction. A client who would normally give $50,000 per year captures the full 37% deduction on that amount in 2025 — worth $18,500 in tax savings versus ~$16,000 in 2026. Funding a donor-advised fund in 2025 achieves the current-year deduction while spreading actual grants over future years.
• Prepaying property taxes into 2025 is limited to the $40,000 SALT cap, but for clients in states with high property taxes, prepaying January 2026 installments before December 31, 2025 captures the full deduction value.
• Electing PTET for 2025 business income may make sense for clients near the MAGI phase-out. The SALT/PTET interaction guide covers when PTET elections still benefit clients above $500,000 MAGI.

4. Shift From Itemized to Above-the-Line Deductions

Deductions that reduce adjusted gross income (AGI) before the standard/itemized decision are not subject to the 2/37 rule at all. Strategies that move deductions above the line include:

• Self-employed health insurance: Fully deductible above the line for sole proprietors and S-Corp owners who participate in the plan.
• SEP IRA or Solo 401(k) employer contributions: Deductible as a business expense, not an itemized deduction.
• Health Savings Account contributions: For clients enrolled in high-deductible health plans, the 2026 HSA contribution limits ($4,300 self-only / $8,550 family) reduce AGI directly.

5. Estate Planning Integration

For clients with significant estate planning flexibility, the OBBBA's $15 million per-person exemption changes the calculus around accelerated gifting. Gifts of appreciated property directly to qualified charities (avoiding capital gains while generating a charitable deduction) may be more valuable than holding appreciated property and itemizing donations in 2026 and beyond. The estate and gift tax planning guide covers the full exemption strategy framework.

The Interaction With Charitable Deductions: A Double Limitation

High-income clients who are also significant donors face two simultaneous restrictions in 2026 — worth modeling together rather than in isolation:

Step 1 — 0.5% AGI floor: Charitable deductions are only allowed to the extent they exceed 0.5% of AGI. A client with $900,000 AGI can only deduct charitable contributions above $4,500.

Step 2 — 2/37 rule: The remaining deductible charitable amount, combined with all other itemized deductions, is then reduced by the 2/37 formula.

Step 3 — 35% benefit cap: Even if a deduction survives both filters, the effective tax benefit is 35 cents per dollar rather than 37 cents.

For a client donating $100,000 in cash with $900,000 AGI, the after-floor deductible amount is $95,500. After the 2/37 reduction, the effective deduction drops further. The actual tax savings from a $100,000 cash gift to a public charity in 2026 may be $30,000–$33,000 rather than the $37,000 they would have received in 2025. Redirecting to a qualified charitable distribution from an IRA bypasses all three of these limitations entirely.

Frequently Asked Questions

Does the 2/37 rule apply to the alternative minimum tax calculation?

No. The AMT calculation starts with a separate income base (AMTI) and does not use the IRC §68 itemized deduction framework. However, AMT and the 2/37 rule can interact indirectly — AMT disallows SALT deductions entirely, which reduces total itemized deductions and therefore may reduce the amount subject to the 2/37 formula. Clients in AMT have a separate analysis.

Can clients avoid the 2/37 rule by filing separately?

Married clients who file separately each have a lower 37% bracket entry point (~$384,000 in 2026), which can increase exposure if both spouses have significant income. Separate filing rarely benefits couples affected by the 2/37 rule; it typically makes things worse because of the lower threshold and other MFS restrictions.

Does the 2/37 rule apply to business deductions taken on Schedule C or passthrough K-1 income?

No. The 2/37 rule only applies to itemized deductions under IRC §63(d). Business deductions that reduce AGI — Schedule C expenses, S-Corp losses, rental losses subject to the passive activity rules — are not affected.

How does the 2/37 rule interact with the $40,000 SALT cap phase-out?

The SALT cap phase-out (above $500,000 MAGI) reduces the allowable SALT deduction before the 2/37 rule is applied. If a client's SALT deduction has already been reduced to zero by the phase-out, the 2/37 rule does not apply to SALT — but it still applies to remaining itemized deductions like mortgage interest and charitable contributions.

Is the 2/37 rule permanent?

Yes. The OBBBA made the IRC §68 limitation permanent as part of the permanent extension of the TCJA rate structure. Unlike the SALT cap, which reverts to $10,000 in 2030, the 2/37 rule has no sunset provision in current law.

What is the maximum deduction reduction the 2/37 rule can create?

The reduction cannot exceed total itemized deductions. The lesser-of test caps the formula at the amount of itemized deductions themselves, preventing the rule from creating a negative deduction.

When should I run the 2026 itemized deduction analysis for affected clients?

Ideally during Q3 or Q4 2025, when enough income has accrued to accurately project year-end taxable income. Clients near the 37% bracket threshold benefit most from early modeling — a relatively small income shift can move them below the threshold entirely, eliminating the limitation.

Arvori helps CPAs model complex planning scenarios like the 2/37 rule across your entire client base — identifying which clients are most affected and which planning moves have the highest leverage. Learn more about how Arvori streamlines high-income tax planning.