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Mortgage Interest Deduction Big in Budget Play
CNBC.com | July 25, 2011 | 12:19 PM EDT

It's not like the housing market needs any more headwinds, so here's the government potentially giving us another: The mortgage interest deduction is back in big play in the budget deal.

It never exactly came off the table, but the bigger the budget deal, the more likely the mortgage deduction will take a bigger hit.

Right now, home loan borrowers can deduct the amount of interest they pay on their mortgages from their taxable income. This goes for principal residences and second homes. The interest deduction is capped at the first million dollars of debt on the home. For home equity loans it's capped at $100,000 in debt.

The deduction costs the U.S. Treasury about $100 billion a year. There are proposals now to either reduce the cap to $500,000 and/or to eliminate the deduction on second homes. Eliminating the deduction on second homes would save about $15 billion, and reducing the cap to $500,000 would save another $15 billion, according to economist William Wheaton at MIT. 10.5 percent of existing home sales in June were of homes over $500,000 according to the Mortgage Bankers Association.

Then there's the idea from the President' bipartisan commission of turning the interest deduction into a 12 percent credit, limited to $500,000 in mortgage debt, only on primary residences. That could save the Treasury $65 billion.

Obviously all this hits the middle class, urban borrowers the hardest because they're the ones with homes in the $500,000 to $1 million range. Realtors, home builders, investors, vacation home owners, even politicians hate these proposals, because they take money out of their pockets and because they provide a strong disincentive to buy a home right now. Then again, others argue that it just fosters over-borrowing, as potential homeowners see the deduction as making the loan less than it really is, which it doesn't.

Interesting, in Canada, they don't have a mortgage interest deduction on personal residences, but they do on investment properties; this makes a lot more sense to me, as it is a business expense. It also fosters investment in housing, which is precisely what the U.S. could use more of right now.

Of course if the US government defaults on its debt, the housing/mortgage markets will have a lot bigger issues to deal with than the potential loss of a tax deduction; like, say, mortgage rates going through the roof.

Questions? Comments? RealtyCheck@cnbc.com And follow me on Twitter @Diana_Olick

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