Federal budget negotiations are moving into a critical period as the government will run out of money by August 2nd unless something is done to stop it. In the last week, President Obama has stepped forward and met with both Democratic and Republican leaders in the US Senate and House of Representatives in an effort to find common ground. There is a lot of huffing and puffing from Democratic as well as Republican leaders. A number of them will have to back down from lines they’ve drawn in the sand if a compromise is to be reached.

The alternatives to avoid exceeding the debt limit include some combination of cuts in federal spending, tax increases to generate new revenue, and increasing the debt limit itself. There is general agreement that the amount needed to close the gap is around $4 trillion. Both parties agree on the need for spending cuts, but Republicans want to cut much deeper than Democrats are willing to go, focusing on far deeper spending cuts in social programs such as Medicare. Conversely, most Republicans are adamantly opposed to any tax increases, while most Democrats would support some business tax increases and personal income tax increases for taxpayers earning over $250,000 annually.

In the mix of possible budget cuts and tax increases are possible changes to the mortgage interest deduction. It is one of the possible alternatives recommended by the National Commission on Fiscal Responsibility and Reform (AKA the President’s bipartisan deficit commission). Their proposal is to reduce the cap on the mortgage interest deduction from the current $1 million level to $500,000, and replace the deduction with a 12% mortgage interest tax credit available to all taxpayers. The latter would create, for the first time, an incentive for home ownership for many moderate income taxpayers. Today many families with incomes below $45,000 who buy homes with mortgages of $140,000 or less get no federal tax benefit from the mortgage interest deduction.

In terms of tax liability they are just as well off – or better off – with the standard deduction. The President’s bipartisan deficit commission estimated that this change would produce a huge amount of new tax revenue, as the proceeds from reducing the cap would far exceed the revenue losses from moderate income home buyers who take advantage of the new 12% mortgage interest tax credit.

The American Homeowners Grassroots Alliance believes the commission’s revenue estimates are likely wrong. The new 12% mortgage interest tax credit is likely to create an explosion of new moderate income buyers who snap up the current huge surplus of inexpensive distressed homes on the market. Everyone who takes advantage of the tax credit will eat into the new revenues generated by reducing the cap on the mortgage interest deductions to $500,000.

The number of consumers who earn less than $45,000 annually is immensely larger than the number of homeowners who earn enough to support a mortgage in the $500,000 – $1,000,000 range. The net result is that the proposal is more likely to reduce federal tax revenues because so many more consumers will have a tax incentive for home ownership. In our minds, this simultaneous increase and redistribution of tax benefits would be good policy however. It would create an incentive for home ownership for moderate income home buyers for the first time, and would revitalize the housing market.

We’d love to hear your thoughts and comments about what the government is considering with the mortgage interest deductions. Do you believe it should change, or stay as it is? Use the comment link below to sound off.