WASHINGTON (Reuters) - The U.S. tax code has many politically sacrosanct tax breaks and few rank higher than the deduction for home mortgage interest.
For decades, politicians have feared even to speak its name, let alone debate putting limits on it, because of its status as a cherished mainstay of the American dream of home ownership.
But that may be changing as Washington grapples with ways to reduce the budget deficit and avert the “fiscal cliff” of automatic spending cuts and tax increases that will begin to take effect on January 1 unless Congress takes action soon.
The mortgage interest deduction is estimated to cost the Treasury about $100 billion a year, making it one of the costliest tax breaks contained in a tax code that has not been revamped in 26 years and is riddled with loopholes.
The deduction allows about 35 million homeowners a year to write off their mortgage-interest payments.
“The mortgage interest deduction used to be a sacred cow that you couldn’t touch; that’s just not the case anymore. For the first time it’s truly vulnerable,” said Jaret Seiberg, senior policy analyst at Guggenheim Securities.
“The difference now is that it is on the list of options that both liberals and conservatives are willing to consider.”
Even if the deduction survives the fiscal cliff unscathed, it would likely come under pressure if Congress undertakes an overhaul of the tax code in 2013. This is not a sure bet, but it looks increasingly possible, according to lawmakers.
Curtailing the mortgage deduction could dampen demand for housing and depress home values, putting a brake on a housing market recovery that is just gaining steam.
Markets where incomes and housing prices are higher - including Democratic bastions such as San Francisco, Los Angeles and New York City - could be hardest hit, studies suggest.
Several hedge fund managers said a possible curtailment of the deduction was weighing on the housing recovery, citing homebuilders such as KB Home (KBH.N) and PulteGroup Inc (PHM.N) as among the most vulnerable.
A cap on the deduction would be a “big damper on new and existing housing,” said Margaret Patel, managing director at Wells Capital Management.
Several forces are driving the momentum to restrict the deduction. Foremost is the $1 trillion deficit, which could be reduced by 10 percent by killing the mortgage deduction alone.
Such a dramatic step is unlikely in the near term. Instead, lawmakers are focused on shrinking the deduction, especially where it most benefits the wealthy.
President Barack Obama has proposed capping itemized deductions at 28 percent of adjusted gross income for high-income households. This could force homeowners to choose between claiming a mortgage tax break or some other kind of deduction.
The maximum amount of eligible mortgage debt for the deduction is currently $1 million for either a first or second home and up to $100,000 on home equity loans.
A December 2010 study on fighting the deficit, known as the Simpson-Bowles report, proposed lowering the limit on eligible mortgage debt to $500,000, as well as killing the deduction for home equity loans and second homes. The report was commissioned by Obama, but he largely ignored it.
The Center for American Progress, a think-tank aligned with the Obama administration, has a tax reform plan that would eliminate the mortgage deduction and turn it into a tax credit.
Beyond fighting the deficit, discussion of curtailing the deduction has economic underpinnings. Some economists and tax policy experts say that, despite its popularity, the deduction encourages consumers to over-borrow.
The tax break is frequently criticized for providing a greater benefit to high-income taxpayers than those further down the income scale and some see it as the type of overly generous housing subsidy that helped inflate the housing bubble.
“It is a generous tax incentive that basically encourages buyers to go after bigger homes,” said Andrew Hanson, an economics professor at Marquette University. “There’s not good evidence to suggest it spurs homeownership.”
Any effort to rein in the deduction will face fierce resistance from businesses in the real estate, construction, mortgage lending and other sectors.
The National Association of Realtors says eliminating the tax break would spur a 15 percent decline in home values.
“We’ve finally bottomed out after a housing recession. Changing the system at this time would be difficult,” said Dave Liniger, chairman of RE/MAX, a global real estate franchise.
Jack Ablin, chief investment officer at BMO Private Bank, a part of BMO Financial Group, said curbing the deduction would hurt builders, finance and construction companies, while residential REITs could benefit if renting became more attractive.
A poll by the Pew Research Center found the American public almost evenly divided on whether to limit the deduction to raise revenue. Forty-seven percent of those surveyed in October supported curbing it, while 44 percent opposed it.
The tricky politics and history of broad support have led some investors to assume the deduction is safe.
“A few things are etched in the minds of most investors,” said David Kotok, chief investment officer at Cumberland Advisors in Sarasota, Florida. “I can see from our own clients (1700 of them) that they assume the home mortgage interest deduction, the IRA and 401k and the 529 plan are safe.” He was referring to the main retirement and college savings plans.
Phillip English, a lobbyist at Arent Fox LLP and former Republican congressman who co-chaired the Congressional Real Estate Caucus, said that assumption could come under attack, even though in his view the housing sector is still too fragile.
“A tax change of this scale remains hard to justify,” English said. “But the fact that it represents a significant amount of revenue keeps it on the table.”
Additional reporting by Jennifer Ablan in New York; Editing by Kevin Drawbaugh, Tiffany Wu and Andre Grenon