It’s not like the housing market needs any more headwinds, so here’s the government potentially giving us another: The mortgage interest deduction is back in big play in the budget deal.

It never exactly came off the table, but the bigger the budget deal, the more likely the mortgage deduction will take a bigger hit.

Right now, home loan borrowers can deduct the amount of interest they pay on their mortgages from their taxable income. This goes for principal residences and second homes. The interest deduction is capped at the first million dollars of debt on the home. For home equity loans it’s capped at $100,000 in debt.

The deduction costs the U.S. Treasury about $100 billion a year. There are proposals now to either reduce the cap to $500,000 and/or to eliminate the deduction on second homes. Eliminating the deduction on second homes would save about $15 billion, and reducing the cap to $500,000 would save another $15 billion, according to economist William Wheaton at MIT. 10.5 percent of existing home sales in June were of homes over $500,000 according to the Mortgage Bankers Association.

Then there’s the idea from the President’ bipartisan commission of turning the interest deduction into a 12 percent credit, limited to $500,000 in mortgage debt, only on primary residences. That could save the Treasury $65 billion.

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Home prices fell 6.7 percent in February year over year, according to a new report from CoreLogic. That numbers includes distressed sales, that is, sales of foreclosed properties or short sales, where the bank agrees to let the homeowner sell for less than the value of the mortgage. If you take those sales out, however, home prices were basically flat.

“When you remove distressed properties from the equation, we’re seeing a significantly reduced pace of depreciation and greater stability in many markets,” notes CoreLogic’s [ CLGX 18.48  -0.33 (-1.75%) ] chief economist Mark Flemming. “Price declines are increasingly isolated to the distressed segment of the market, mostly in the form of REO sales, as the stock of foreclosures is slowly cleared.”

Distressed sales, though, still make up more than a third of all home sales, according to the National Association of Realtors, and that number is likely to rise at least in the near future. The banks have slowed the process of foreclosure, and that has reduced the number of bank owned properties hitting the market lately, but it’s a whole different story with short sales.

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We didn’t need KB Home’s dismal quarterly earnings release today to tell us that foreclosures are digging home builders into an even deeper hole.

We knew that already; this just put a period on it.

KB [ KBH 11.69  +0.00 (+0.00%) ] caters to first time home buyers, with smaller, less expensive homes. Unfortunately, bargain basement foreclosures, many of which are relatively new construction, offer more home for the money, and first time buyers are making up less of the buying population today than historical norms.

Right now banks are pushing foreclosures to market faster than ever, perhaps due to improving paperwork procedures, and perhaps due to the fear of some kind of settlement/penalty coming down the pike from state attorneys general and federal regulators. In any case, the volumes are rising, and that hurts home prices and home builders.

“We continue to think prices will be under pressure throughout 2011; we may have to re-evaluate all of our assumptions given the weakness we’re seeing right now,” notes analyst Buck Horne at Raymond James.

So what’s a builder to do?

Well, Lennar [ LEN 18.32  +0.00 (+0.00%) ] has been investing in troubled mortgages through its Rialto Capital Advisors division, and that has helped boost its bottom line.

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