The federal mortgage interest deduction acts as an incentive for homebuyers to take on bigger mortgages than they might need, making it harder to safeguard the financial system against systemic risk, the president of the Federal Reserve Bank of Minneapolis told bankers meeting in Montana this week.

Lowering the fraction of mortgage interest households are allowed to deduct from their taxable income would help protect the financial system in the event of another housing boom and bust, Minneapolis Fed President Narayana Kocherlakota said.

If policymakers want to encourage homeownership, he said, they could replace the mortgage interest deduction altogether with a tax credit that offsets part of a buyer’s down payment on a home.

Kocherlakota said tax deductions for corporate borrowing should also be scaled back, because they serve as a "debt tax shield" that encourages financial institutions to take on debt instead of attracting deposits.

If policymakers want to encourage business investment, they could replace the corporate interest tax deduction with a lower corporate income tax rate, he said.

Higher levels of debt for households and financial institutions make the financial system more susceptible to shocks like falling home prices, and providing tax incentives for taking on more debt increases the level of risk, Kocherlakota said.

A family that has $150,000 invested in stocks and bonds and wants to buy a $300,000 house, for example, could use their assets to cover half the cost of the purchase, taking out a $150,000 mortgage to cover the rest of the sale price.

But the mortgage interest deduction can make it more attractive for the family to take a more leveraged position — making a $60,000 down payment and borrowing $240,000, for example — because interest payments on the additional debt are deductible.

Similarly, a financial institution that needs an extra $1 million has a tax incentive to raise that money by issuing debt, instead of attracting deposits that it must pay interest on.

"The U.S. tax system encourages household leverage and bank leverage, even though both are potentially destabilizing," Kocherlakota said.

Only about one-third of U.S. households itemize deductions on their tax return — meaning that at least two-thirds aren’t claiming the mortgage interest deduction. But more than 60 percent of households making over $50,000 do itemize, as do more than 75 percent of households making more than $75,000, he noted.

About one in five households with mortgages are underwater, Kocherlakota said — thanks in part to tax incentives that encouraged them to take on more debt.

While Kocherlakota thinks changes to the tax code would limit behavior that helped bring about the global financial crisis, the mortgage interest deduction has also been called into question by analysts studying ways for the U.S. to get a handle on the rising government debt.

The Joint Committee on Taxation last year estimated that the mortgage interest deduction provided $86 billion in tax breaks during fiscal year 2009, a figure that was expected to rise to $135 billion by 2013.

Reducing or eliminating the deduction wouldn’t necessarily result in a corresponding increase in tax revenue, however, because it might also have other economic consequences.

The National Association of Realtors and other real industry groups are opposed to any changes to the mortgage interest deduction, saying it helps families become homeowners and that eliminating it would further undermine home prices.

A bipartisan deficit reduction commission last year recommended converting the mortgage interest deduction into a 12 percent nonrefundable tax credit, with only interest paid on debt of up to $500,000 on a principal residence eligible. Currently, interest paid on up to $1 million in debt on both a principal and second home is deductible.

Some beltway insiders think major changes to the mortgage interest deduction are unlikely, because it’s a "sacred cow" that is popular with homeowners.

Critics say the mortgage interest deduction benefits the wealthy the most, because households in the highest tax brackets get the biggest deductions.

The Obama administration has sought to cap itemized deductions for high-income taxpayers, reducing their value by nearly one-third, but so far lawmakers have not gone along.

The mortgage interest deduction currently saves a family in the 35 percent tax bracket with a new $500,000 mortgage about $8,680 in the first year of the loan.

If the cap was lowered to 28 percent, as called for in the Obama administration’s proposed 2012 budget, the mortgage interest deduction would be worth about $6,900 to the same family.

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