Which Tax Deductions Are Most Likely to Go?

Tax Deductions
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Tax loopholes and deductions are under immediate scrutiny in efforts to cut the deficit and raise revenues as Capitol Hill battles to avoid the sequestrations — the massive automatic spending cuts set to begin March 1.

Congressional hearings have begun on the most well-known, and according to some experts, most likely to be reformed or eliminated. Among them: charitable deductions, deductions on home mortgage interest, the so called carried interest — the tax break for private equity and hedge fund managers — and limiting tax deductions on corporate profits.

(Read More: Obama Warns Sequester Will Cause Job Losses)

Loopholes and tax breaks cost the Treasury more than $1 trillion each year, according to government estimates. Among the biggest losses come from tax breaks for U.S. corporations — $114 billion — the mortgage interest deduction — an estimated $77 billion — and charitable donations — $38 billion.

Each of the parties at risk are fighting back. Several charitable groups testified before Congress recently, saying that if their deduction is lowered or eliminated, people will stop giving.

The housing industry — most specifically builders — say the mortgage interest deduction is necessary for the housing market to recover from its recession lows. Corporations say their U.S. tax rates are the highest in the world, at 35 percent.

Hedge funds and private equity firms say part of their fees are based on risk, and therefore their tax rate — which was just raised with the fiscal cliff deal from 20 to 25 percent — should be treated like an investment instead of a salary, and therefore taxed at a different rate. (Read More: Home Builder Confidence Falls)

"Charitable deductions and mortgage interest deductions are more encouragement by the government for people to do things, rather than tax loopholes," said Ian Shane, a tax attorney with the law firm, Golenbock Eiseman Assor Bell & Peskoe.

"By that I mean the government is subsidizing the buying of homes and the giving to charities with the deductions," said Shane. "It's true that reducing or eliminating those would hurt a bit but I don't think people would stop giving to charities or buying homes if they were gone."

"In fact, the mortgage interest deduction really helps wealthier people instead of those who need it. Why should renters not get some sort of benefit since they can't afford to buy a home?" Shane said. "I think the best things would be to phase it out over time."

As for charitable giving, Shane said most people take an altruistic approach rather than just looking at their tax returns.

"When you have relief funds for Hurricane Sandy or some other disaster, most people give because they want to rather than feeling the need for a deduction," Shane said. "It's the American thing to do — give to charities. I don't think there's any other country like this when it comes to helping others. Those that are rich and give big money to charities don't need the deduction."

When it comes to carried interest — where private equity and hedge fund managers share in the profits of an investment fund they manage with the rate of taxation at 25 percent — critics say it's unfair to let money mangers be taxed at lower rates than other workers for what is essentially a paycheck.

One analyst said the hotly debated issue — one President Barack Obama said should be changed — is built around perception. (Read More:Can you Trust Your Taxman)

"There's a perceived unfairness about it and it's more an argument of social equity," said Mitchell Gaswirth, a partner in the tax department of the law firm Proskauer. "You can make the case that they are partners in the investment and deserved to be tax accordingly, like other investors. It's highly charged. But I'm not sure that closing it would raise all that much money."

As for changes in the tax code for corporations critics point to a company like General Electric, which through domestic and overseas deductions and credits paid no federal taxes in 2011, though it did pay state local and payroll taxes.

But lowering the corporate rate seems to be gaining popularity among Democrats as well as Republicans. Senate Finance Committee Chairman Max Baucus (D-MT.) released a statement Friday saying that "a lower corporate tax rate and simpler code will create jobs and boost economic growth."

Both Shane and Gaswirth agree that closing loopholes while lowering the rate — currently at 35 percent — would help motivate corporations to pay their fair share.

"Corporations lobby hard to get their taxes reduced, and it seems only the smaller firms really pay their full taxes," said Shane. "But the bigger corporations do a lot abroad and they're multinational. The tax codes we have are 10 years behind the times on that. They need to change."

"The best thing would be to close all the loopholes for corporations whatever they are but lower the rates," said Gaswirth. "It would be much easier for them to pay the lower rate with out all the deductions."

What analysts said needs to happen with tax deductions and tax reform itself — in order to raise revenues and make it fair — is a completely new way of thinking about what taxes are meant to do.

"Closing the loopholes would help with revenues but they don't really help enough," said Shane.

"We need to make the tax code efficient and get rid of all the deductions," said Gaswirth. "We haven't had major tax reform since 1986. It's way overdue. If we want real revenue, we need to use the tax code for that, not social engineering. If we want solar power, Congress should just fund it, instead of giving tax deductions.

"Let's make tax codes do what they were supposed to do — raise money and not bring about social engineering."