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Fiscal Cliff Decision May Have Big Impact On Housing Market

Regardless of how lawmakers choose to deal with the looming fiscal cliff, the U.S. housing market — now seeing a surge of activity and investor interest — will feel an impact.

It could be positive or negative, depending on what Washington does about this combo of government spending reductions and tax cut expirations. They trigger at the end of 2012 and early in 2013, and could potentially lower the public debt by $7.1 trillion over a decade.

If lawmakers take a moderate approach — extending most tax cuts and mortgage interest deductions through 2012 — the impact on housing would be positive, analysts say.

But by running right off the cliff in the name of fiscal prudence — letting tax cuts expire, slashing spending and doing away with homeowners' mortgage interest deductions — the finally recovering housing market might take a big hit.

"The best-case scenario is a deal that avoids sharp tax increases and spending cuts next year," said Jed Kolko, chief economist at real estate website Trulia (TRLA). "With that kind of deal, you would avoid stalling or reversing the economic recovery while at the same time creating a long-term path for getting the government budget more in balance.

With the U.S. national debt now topping $16 trillion, some economists would rather see strong action on the deficit soon. Last week, former Federal Reserve Chairman Alan Greenspan said in an interview with Bloomberg Television that letting taxes rise would be a small price to pay to get Congress to OK spending cuts on entitlement programs, even if that produces a "moderate recession.

Action Vs. Inaction Kolko concedes that something needs to be done to reduce the federal deficit and balance the budget, at least over the long term. What he and others don't want to see is President Obama and members of Congress taking drastic measures.

"Our main concern is that the tax reform effort be done in a more measured, careful way," said David Crowe, the National Association of Home Builders' chief economist.

Like Kolko, Crowe would like to see tax cuts extended until the economy is in a better position to withstand rising taxes. He'd also like to see housing tax credits, deductions and other incentives left in place.

"What worries us is that the effort to balance federal spending could fall on the backs of the housing sector just as it's beginning to assist in the economic recovery, he said.

Indeed, recent data continue to point to an improving housing industry and investors have been gravitating toward homebuilder stocks.

IBD's Building-Residential/Commercial industry group ranks No. 4 of 197 groups tracked, with its largest names — Lennar (LEN), Pulte Group (PHM), D.R. Horton (DHI), Toll Bros. (TOL) and NVR (NVR) — all up at least 3% this week through Wednesday.

On Monday, the National Association of Realtors reported that existing-home sales in the U.S. climbed 2.1% in October to an annual rate of 4.79 million units. That was above the median forecast of economists in a Reuters survey for a 4.75 million-unit rate. The inventory of existing homes for sale in the U.S. declined 1.4% to 2.14 million, the lowest level since December 2002.

The Commerce Department said Tuesday that housing starts in October rose 3.6% from September to an annual rate of 894,000. That rate was up 41.9% year-over-year.

"The current housing market recovery is being fueled by fundamentals like incredibly high housing affordability. As such, it can weather the weak recovery in the broader economy we're currently seeing," said Stan Humphries, chief economist at real estate website Zillow (NASDAQ:Z).

But the market is "not completely immune to political and economic shocks either," he said. "We should avoid testing just how resilient housing can be to external events.

Observers say one way to avoid some fiscal cliff economic shock would be to extend for 2013 the Bush-era tax cuts — which lowered the hit to income, investments and families — so Americans have extra cash to pump into the economy.

"If these cuts are extended, it would mean more money in people's pockets to spend on things to help create jobs," Kolko said.

The worst-case scenario, he says, would be to "let all the tax cuts expire and all of the spending cuts be implemented. Both of these would hurt the economy and housing.

Housing industry executives are keeping an eye on how lawmakers will deal in early 2013 with the mortgage interest deduction used by homeowners itemizing their taxes.

Mortgage Interest Deduction One proposal being batted around is to cap it at $500,000 of home value instead of the current $1 million. Another would limit it to primary residences. There also is talk of eliminating the deduction for taxpayers earning $250,000 or more.

The reason mortgage deductions are being eyeballed is that they represent a substantial source of potential income for the federal government, Humphries says.

"The mortgage interest deduction is attractive to budget cutters because (it represents) about a $100 billion loss in annual revenue for the government," he said. "But it's also politically charged since about a third of taxpayers itemize their deductions.

About 35% of itemizers' deductions are mortgage interest, he says.

Real estate groups are lobbying to keep the deduction intact.

In a letter to a joint congressional committee a year ago, the NAR warned that cutting the deduction cap to $500,000 "would further reduce the value of homes" — an erosion "unthinkable" atop the 30% reduction in value that had already occurred as the housing bubble burst.

"We certainly have taken the threat of reduced incentives as a cause for concern because they will impact someone's decision to buy a home," the NAHB's Crowe said. "We are monitoring activity to learn where these discussions are going, but we are as mystified as everyone else as to exactly what will happen."