1. The mortgage tax deduction reduces the cost of ownership for those holding a mortgage. It effectively reduces the interest rate on a qualifying mortgage. Thanks to the mortgage interest deduction, a mortgage payment (PITI) costs $x per month instead of $x + $y (where $y represents the effect of the interest rate reduction).
2. Most consumers who will buy homes with mortgages benefit from this reduced cost of ownership.
3. Given that consumers are often concerned about how much they can afford for housing on a monthly basis, reducing the cost of ownership in the form of the mortgage deduction allows the consumer to pay a higher purchase price for the home.
4. As other consumers are in the same situation, they too are willing to pay more.

How big the effect would be, who can say? But I believe that it's not likely that low-income folks (or even us middle income folks) are much helped by the deduction. The current situation represents a market distortion because it makes prices higher than they should be and it favors purchasing with a mortgage rather than cash.

I doubt we'll be seeing the end of it any time soon, though, as politicians will be afraid of killing the housing market.
-Brian

A while back I wrote a post on “the never ending homebuyer tax credit” addressing this issue:

http://raincityguide.com/2009/12/16/8150/

Now that the government and the housing industry has learned that buyers of homes value cash up front, in hand, more than the long term mortgage interest deduction, they would be wise to make a change.

I don't think you can retroactively cancel the deduction for people who purchased homes in the past. But I do think it is time for a one time election for either an up front tax credit OR a long term mortgage interest deduction.

It's not even a question, Rob. Buyers clearly get all starry eyed and giddy over thousands of dollars today, vs the mortgage interest deduction. Though in all fairness, the mortgage interest deduction is a buy factor in the rent vs buy scenario IF and only if, rents are equal to mortgage payments. I do not work in one of those markets…but much of the Country falls in that category.

An irrevocable election at time of purchase for the cash today or the long-term deduction, would be a smart move for government officials to get behind.

Also, in the state of Arizona it is not the place of real estate agents or brokers to counsel real estate clients on tax and/or legal matters. It could and would be a gross breach of ethics and law for us to do so – and to counsel my clients on the possible income tax advantages or disadvantages of home-ownership is IMHO WAY beyond my area of expertise.

@RobHahn – The income tax deduction for mortgage interest has not one time in my 13 year career ever been a major consideration or issue with any of my clients. Yes, it's been brought up in casual conversation, but I've never seen it be the motivating factor behind a client purchasing a home.

Don't forget that the real estate agent works for the seller, not for the buyer, even if the buyer is operating under a different assumption. The agent is there to make the deal happen, not to protect the interests of the buyer. He/she is never going to tell the buyer that the possible income tax deduction might not be of any use to them.

The standard deduction for a married couple is $11,400. If property taxes are $3,000, interest would need to be $8,400, which at 5% interest would require a $168,000 mortgage principle to make itemization worthwhile. If property taxes are $5,000, interest would need to be $6,400, which would require principle of $128,000. If we accept the old rule of 28% of gross income for PITI, and recognize that first year principle payments are trivial, and call insurance $0, $11,400/.28 requires a gross income of about $41,000.

Supposed tax benefits make a very nice fudge factor for people who aren't sure they can afford a particular house. The agent can murmur sweet nothings about those potential benefits. By the time the following April rolls around, or rather the first April after full January-December year rolls around, and the tax benefits don't show up, the commission will have been paid, as will the fees to the mortgage broker and title insurer (and its agent, the lawyer) and lots of others who benefit as part of the FIRE sector, including the seller.

Isn't the Mortgage Interest Deduction wonderful? See how it fires our economy? (See what it does to the unsuspecting?)