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The mortgage interest tax deduction, long thought to be a “sacred cow” impervious to tampering, now may be on the chopping block as the government considers its options in how to apply the $1.8 trillion in spending cuts over the next 10 years. The subsidy allows homeowners to deduct the interest costs of their mortgage for up to $1 million; however, studies show that only a third of mortgage holders utilize the claim. Even so, many experts believe it’s a valued incentive for homeownership even though the wealthy are those who benefit most. For more on this continue reading the following article from TheStreet.

The housing industry will be paying close attention to President Obama's budget proposal to be announced Wednesday morning.

With the Administration targeting a $1.8 trillion reduction in the deficit over a ten-year period, the government's significant subsidy to the housing sector may be on the chopping block.

Among the most costly tax subsidies is the mortgage interest tax deduction, which the Joint Committee on Taxation estimates will reduce revenues by $70 billion in 2013 and by $379 billion between 2013 and 2017.

Homeowners can currently deduct interest payments on home mortgage balances up to $1 million from their taxable income. They also can deduct interest on home equity loans of up to $100,000. Within these caps, taxpayers can claim deductions on up to two homes.

The mortgage interest deduction, however, is an "itemized" deduction that only a third of American tax filers are said to claim. Most middle-class households do not itemize their deductions. Rather they just take a standard deduction - capped at $6,100 for a single person and $12,200 for a couple.

Still, realtors believe that the subsidy plays an important role in promoting homeownership. Previous proposals to alter or eliminate the deduction have been met with howls of protest from the housing lobby, who argue that the elimination of the tax break would hurt the fragile housing recovery.

Mortgage Interest Deduction, An Unfair Subsidy

However, there has been growing support for reforming the deduction in recent years, as critics argue that the tax breaks unfairly favor the rich more than the middle-class.

Jared Bernstein, Senior Fellow at the Center on Budget and Policy Priorities(CBPP) calls the deduction "a picture of an expensive, inefficient, and unfair tax break."

He points to a recent CBPP paper that shows the bulk of the deductions go to higher income households. In 2012, 77% of the benefit went to households with incomes greater than $100,000. Some 35% of the benefit went to households with incomes greater than $200,000.

Higher income households are able to deduct more from their taxable incomes because they tend to take bigger mortgages and therefore pay more in interest. Their absolute savings in tax as a result of the deduction is also higher than middle-class households, due to their higher income tax bracket.

The paper also questions whether the deduction really impacts home ownership decisions. "Higher-income households are more likely to be deciding how expensive a home to buy or how large a mortgage balance to maintain than whether to buy a home at all. Meanwhile, lower- and middle-income households, who are more likely to be on the margin between buying and renting a home, receive a much more modest benefit (or no benefit at all) from the deduction," the researchers wrote.

The subsidy is also tied to homeowners tax liability, which means it does not help troubled borrowers. "...the deduction is poorly suited to help struggling homeowners keep their homes. Homeowners whose incomes decline will receive a smaller subsidy if they fall into a lower marginal tax bracket. And homeowners whose incomes drop to the point where they owe no federal income tax that year (for example, because they lose their jobs) would lose the value of their deduction altogether, precisely when they are most likely to have difficulty making mortgage payments."

The Obama Administration has tried but failed to alter the deduction so that more middle-class households benefit. In each of the last four years it has proposed capping itemized deductions at 28%. This would lower the deductions for those in higher income tax brackets, while keeping the deductions unchanged in the lower income brackets.

Other plans have proposed lowering the limit on deductions to $500,000 and eliminating the mortgage interest deduction on second homes.

The CBPP proposes replacing the deduction with a tax credit that would be a percentage of mortgage interest. "A credit, unlike a deduction, would benefit homeowners whether they itemize or claim the standard deduction," the paper explains. "And the tax benefit, rather than varying based on a household's marginal tax rate, would be a fixed percentage of the household's mortgage interest. This would shrink benefits for households in higher tax brackets but expand them or leave them unchanged for households in the lower brackets. "

The researchers estimate that the tax credit would increase subsidies to lower income households by more than 30% and will help 16 million more homeowners.

Besides the mortgage interest deduction, the budget proposal could also have other important implications for mortgage finance.

Will FHA Draw From Treasury?

The budget will likely provide an updated estimate on the Federal Housing Administration's financial health. The agency said late last year that it is likely to have a $16.3 billion shortfall in its reserve fund and that it may have to request the Treasury for funds for the first time in its history.

The recovering housing market may have reduced the projected shortfall, but only marginally.

The FHA has been hiking its premiums and tightening lending standards to reduce the projected shortfall, but there is now a bipartisan effort to overhaul the agency, which some say is only one recession away from a bailout. The FHA has up to Sept. 30 to determine if it needs to draw funds from the Treasury.

The government's refinance and mortgage modification programs are due to expire at the end of 2013. The refinancing program has received a lift in the past year after changes announced in late 2011, while the modification program is still short of the Administration's targets.

Still, with more than 10 million homeowners still underwater, the government is under pressure to continue its mortgage aid. Any proposal to extend the programs will be welcome news for both borrowers and will also benefit banks such as Wells Fargo (WFC), JPMorgan Chase (JPM) and Bank of America (BAC) that have big mortgage businesses.

Will Fannie, Freddie Repay Treasury?

Finally, there is the gargantuan problem of what to do with housing finance giants Fannie Mae (FNMA) and Freddie Mac (FMCC) that are still in conservatorship. Granted, the budget is not going to tackle this controversial question, but the fact that the agencies have returned to profit and may be in a position to repay the government has obvious implications for the taxpayer.

Currently all of Fannie Mae and Freddie Mac's profits go to the Treasury, but they count as dividends rather than a repayment of bailout money. Until the government decides what to do with Fannie and Freddie, the Treasury can milk the billions in dollars it gets from the agencies.

Some investors are betting that the housing giants will soon repay the government and have money left for shareholders.

That idea disregards political reality, according to some analysts, since neither party has any desire to return the agencies back to their private form.

The budget proposal may contain some language that allows for private capital to return to the mortgage market, such as further increases in the agencies' guarantee fees and charting a path towards sharing credit risk.

This article was republished with permission from TheStreet.