Lawmakers are eyeing a popular tax deduction for mortgage interest as they look for ways to fill record budget deficits, although any changes are likely to await a broad reworking of the tax code.

Two forces are conspiring in a way that could put the long-cherished deduction on the chopping block: a need to raise more revenues and a feeling among policymakers that government incentives for housing have been too generous.

It's a confluence of several factors. First, it's such a large tax break, said Donald Marron, director of the Urban-Brookings Tax Policy Center. And the tax treatment of housing is much more favorable than we provide for most other investments people undertake.

A bipartisan group of U.S. senators, known as the Gang of Six, pushed a debt plan last week that embraced changing the deduction to help achieve $1 trillion in revenues and reduce deficits by nearly $4 trillion over the next decade.

The proposal comes as Democrats and Republicans rushed on Thursday to rework rival deficit reduction plans to avert a crippling U.S. default.

The government has allowed home buyers to deduct a portion of the interest paid on mortgages for decades as a way to promote home ownership.

Efforts to curtail the deduction have gained ground as a way to curb the nation's growing debt, and while the latest dueling deficit-cutting plans in Congress do not commit to take the tax break away, plans to curb it could resurface.

The plan left it to congressional committees to decide how the tax break would be trimmed, but any legislation should reform, not eliminate the deduction.

The deduction, which costs the U.S. Treasury about $100 billion a year, is the largest subsidy for homeowners and the nation's third-largest tax break, according to the Center for American Progress, a liberal policy research group.

About 35 million households claimed the mortgage interest deduction in 2009, according to the Joint Committee on Taxation, the congressional scorekeeper on taxes.

The deduction's popularity and its connection to the American dream of home ownership has made it sacrosanct politically. But that may have changed.

There is more interest in the mortgage interest deduction, and it has more momentum than it has had in the past, said Brian Gardner, senior vice president for Washington research at Keefe Bruyette & Woods Inc.

TURNING DEDUCTION INTO TAX CREDIT

A presidential budget commission last year proposed turning the deduction into a 12 percent tax credit for buyers. The plan, which languished after being presented to Congress in December, would have capped the credit at $500,000 in mortgage debt and limited it to primary residences.

Gardner said Congress was more likely to revive that proposal than wipe out tax-related support for housing altogether.

However, he said any consideration of the measure would likely await a broader debate on tax reform -- and that will not heat up until lawmakers return from an August break.

It's a tough issue to handle, and if it is not married to broader tax reform then it just becomes tougher.

Even then, the powerful housing industry lobby could persuade Republicans and Democrats alike to keep the deduction in place.

The Mortgage Bankers Association (MBA) and the National Association of Realtors are arguing that repeal would undermine a weak housing recovery.

The mortgage interest deduction is important because it keeps the housing market functioning, said MBA President David Stevens. We are very concerned about what would happen as the outcome to an industry that fuels 30 percent of gross domestic product if it was removed.

POST-BUBBLE BLUES

The deduction has frequently been criticized for providing a greater benefit to taxpayers with higher incomes than those further down the scale. The maximum amount of eligible mortgage debt for the deduction is currently $1 million.

However, John Weicher, director of the Hudson Institute's Center for Housing and Financial Markets, said a repeal would mostly pinch households with incomes between $75,000 and

$200,000.

Weicher, who served in the U.S. Department of Housing and Urban Development during the administration of former president George W. Bush said killing the deduction would not only harm the housing market but undermine the goal of fostering home ownership.

It would put buyers at a disadvantage and create a new bias in the tax code that favors renting rather than owning your own home, he said.

But many analysts argue that incentives for home ownership need to be realigned to the prevent type of bubble that led to the devastating 2007-2009 financial crisis.

The U.S. home ownership rate peaked at 69.2 percent of the total U.S. population in 2004, according to the U.S. Census Bureau, as lax lending standards fueled home sales.

By the first quarter of this year, it dropped to 66.4 percent.

There is a longstanding American emphasis on home ownership that has gone to extremes, Urban-Brookings' Marron said. It is something that encourages people to take on a lot of mortgage debt. To be frank, mortgage debt isn't as popular today as it used to be.

(Editing by Jeffrey Benkoe)

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