A rally in Swedish home prices that made its housing market one of the world's frothiest is reigniting political calls to remove a controversial tax perk seen as part of the problem.

There's consensus in parliament that a 30 percent reduction on mortgage-interest costs should be phased out, a move backed by both the central bank and the country's financial regulator. But the two ruling parties in Sweden's teetering minority coalition are split over the urgency of carrying it out.

The housing rally there mirrors property booms from Canada to New Zealand, and was ranked by Bloomberg Economics in the past month as Europe's bubbliest. Such dynamics are pushing some monetary authorities toward raising interest rates, but the Riksbank is reluctant to do so as it focuses on its inflation target is shifting focus to other options.

Sweden stands out alongside the US as one of the countries that still allows mortgage-interest deductions, in what is essentially a middle-class tax incentive for home ownership. Tweaking such policies can be precarious, as witnessed in the UK, which suffered a housing crash lasting years after it curtailed a similar measure in 1988.

"There is definitely a move toward acknowledging that something more significant may need to be done, but it's not easy," Helena Bornevall, an economist at Handelsbanken, said in a phone interview.

"There is always a risk to the market if you take radical measures too rapidly."

That's the worry giving Sweden's coalition pause for thought. Financial-Markets Minister Asa Lindhagen, of the Green Party, seeks to start phasing out the deduction as soon as next year, while Social Democrat Finance Minister Magdalena Andersson wants to negotiate a wider political deal before reducing the incentive. They agree, though, that any changes should be gradual.

"It needs to be predictable and it has to be done slowly, and you need to make sure that households are compensated," Andersson told journalists earlier this month.

Heightened political sensitivity

While house prices in the largest Nordic nation have increased by about 20 percent in the last 12 months, there's heightened political sensitivity about real estate after a crisis triggered in June by plans for rental-home deregulation almost prompted the first snap elections there since 1958.

Removing the tax incentive would, in theory, add about SEK 20bn (USD 2.3bn) to the government's coffers, though no one advocates removing the tax break in one go.

Robert Boije, the chief economist at state-owned mortgage lender SBAB, warns that Swedish home prices could drop as much as 30 percent if interest deductions on mortgages were abolished, according to an opinion piece in Dagens Industri.

Sitting atop a volcano

Sweden's house-price gains of about 74 percent since 2010 are higher than the European Union average of 31 percent, but in line with Germany's increase and lower than Estonia's, which saw the steepest price hikes in the 27-member bloc, at 127 percent, according to Eurostat data.

Riksbank Governor Stefan Ingves recently compared the country's rise in household debt to sitting atop a volcano. Sweden could find itself "in a scenario that is difficult to manage" if housing imbalances aren't dealt with, he said at a recent central-bank meeting.

His own institution faces criticism itself for keeping interest rates low and purchasing the covered bonds that finance the country's mortgages with its quantitative easing.

Only the Moderates, currently Sweden's largest opposition party, are explicitly opposed to a tax reform, while others want a gradual reduction to avoid irking voters who benefit from property taxes reckoned by the International Monetary Fund to be "extremely low".

Signs of a cooldown

There are signs of a cooldown. Residential property prices declined 0.5 percent on the month in June, with the annual price increase slowing to 16.8 percent from 17.9 percent in May, according to the Nasdaq OMX Valueguard-KTH Housing Index, HOX Sweden. Single-family homes, driving the rally, also depreciated by 0.8 percent from May.

For now, the main impending action to cool prices is the reinstatement by Sweden’s financial watchdog of mandatory mortgage amortization next month, though analysts don't expect that to achieve much.

Phasing out the tax incentive should have been done years ago, according to Nordea economist Torbjorn Isaksson. He reckons politicians should now proceed carefully.

"The deduction should be reduced, even if it is a bit late," he said.

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