WASHINGTON - With a key lawmaker proposing a cut in the mortgage interest tax deduction, the issue is once again heating up.

Sen. Bob Packwood, R-Ore., who chairs the Finance Committee, recently proposed that the home mortgage interest deduction be trimmed.

Currently, interest on $1 million in mortgage debt qualifies for the deduction. Mr. Packwood proposed that interest on only $250,000 be eligible for a deduction in the future.

He suggested that the increased revenue could help pay for a cut in the capital gains tax rate, to 17% from 28%.

Despite the budget-cutting fever in Washington, many believed that the lucrative deduction would not be seriously debated until at least next year. But now lobbyists say otherwise.

Robert Bannister, senior vice president of the National Association of Home Builders, said his group was warning lawmakers that cutting the deduction would have disastrous consequences for the nation's banks.

Mr. Bannister argues that cutting the deduction will result in a drop in home prices, a shrinkage of borrower equity, and ultimately higher defaults.

He said he expects the issue to be hotly debated as lawmakers explore the flat tax. Such a tax, which would eliminate all deductions, is championed by the House majority leader, Rep. Richard Armey, R-Tex.

Mike Ferrell, senior staff vice president and legislative counsel of the Mortgage Bankers Association, said his group was actively lobbying against the cut, which it believes would punish homeowners.

Separately this week, the Congressional Budget Office laid out several ways to eliminate or limit deductions for mortgage interest.

In an annual report on reducing the federal deficit, the CBO suggested the government could entirely eliminate the deduction, reduce the principal eligible for interest deductions to $300,000, cap interest deductions, or limit deductions for second homes.

The CBO estimated that reducing the debt eligible for a deduction to $300,000 would raise $34.8 billion over five years.

The CBO said that this change would reduce deductions only for about 1.2 million taxpayers who own relatively expensive homes.

The change would not affect the vast majority of homeowners, the report said. More homeowners would be affected in high-cost areas like Honolulu and San Francisco, the CBO said.

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