Five years ago, the phasing out of mortgage interest tax relief – one of the last acts of former Chancellor George Osborne before he departed No 11 – began in earnest.

2020-21 was the first tax year where the new mortgage interest tax credit relief has applied.

The measure was designed to make buy-to-let less attractive and profitable as an asset class to improve the chances of budding homeowners getting on the ladder. However, many landlords have sought to circumvent the changes by incorporating their portfolios for greater tax efficiencies.

What did the phasing out involve?

The measure, gradually phased in since April 2017, restricted relief for finance costs on residential properties to the basic rate of income tax.

Since April 2020, landlords have no longer been able to deduct all of their finance costs from their property income to arrive at their profits – as was the case before. Instead, they receive a basic rate reduction from their income tax liability for their finance costs.

The phasing out occurred in the following way:

  • in the 2017-2018 tax year, the deduction from property income was restricted to 75% of finance costs, with the remaining 25% being available as a basic rate tax reduction
  • From 2018 to 2019, this fell to 50% finance costs deduction and 50% given as a basic rate tax reduction
  • From 2019 to 2020, it was a 25% finance costs deduction and 75% given as a basic rate tax reduction
  • and from 2020 to 2021, all financing costs incurred by a landlord have been given as a basic rate tax reduction (20%).

This has been bad news for higher-rate taxpayers, which many landlords fall into, who effectively received 40% tax relief on mortgage payments under the previous system.

According to Which? the new system means 'higher or additional-rate taxpayers can no longer claim the tax back on their mortgage repayments', as the credit only refunds tax at the basic 20% rate, rather than the top rate of tax paid.

Less obviously, it adds, the new rules could force some landlords into a different tax bracket, as they'll need to declare the income that was used to pay the mortgage on their tax return.

This could push a landlord's total income into the higher or additional rate tax brackets, depending on their income from other sources, for example, salary or pension.

Which? offers the example of a landlord receiving £950 per month in rental income, with mortgage interest payments of £600 per month. The website says they'll pay tax on the full £11,400 rental income they earn and therefore pay £7,200 in mortgage interest. They'll receive a tax credit of £1,440 (£7,200 x 20%).

A basic rate taxpayer will pay £840, no increase compared to the previous rules. However, for a higher-rate taxpayer, the cost will be £3,120 - double the amount payable under the old system.

This is why so many landlords and those in the lettings industry have been critical of the move.

What are the alternatives?

Incorporating – the act of forming a limited company, in which a landlord's portfolio is kept, subject to corporation tax rather than income tax – has become increasingly popular in the years since the phasing out began.

There are pros and cons to such an approach, but as the changes to mortgage interest tax relief only affect individual private landlords or those running a property portfolio as a couple, the concept of turning a portfolio into a business means the portfolio becomes immune from the changes.

However, it's advised that landlords consider carefully whether this is the right move for them, with mortgage rates for businesses typically much higher. At the same time, an extra round of stamp duty will be owed when the ownership of the property is transferred from you as an individual to the business.

That said, it is hard to beat as a way around the changes, which is why its popularity has soared since 2017.

In 2021, a record number of companies were created to hold buy-to-let property. According to Companies House data, there were 47,400 new buy-to-let companies incorporated in 2021 across the UK.

This is almost twice the number set up in 2017 when mortgage interest tax relief changes were first introduced.

Nevertheless, there are signs that the level of growth is starting to fall, with new incorporations declining compared to previous years. There was a 14% rise recorded between 2020 and 2021, down from 30% between 2019 and 2020.

Buy-to-let companies currently hold 583,000 mortgaged properties, representing approximately 29% of all existing BTL mortgages nationally. What's more, this figure has increased from 26% over the last 12 months.

Despite the growth in buy-to-let incorporations, about 25,100 have closed their doors since the start of the pandemic, with 15,200 closing in 2021, equating to 6% of all buy-to-let companies currently up and running.

How has it impacted landlords?

Despite fears that the phasing out of mortgage interest tax relief would lead to an exodus of landlords, especially as it came only a year after the additional 3% stamp duty surcharge was introduced, this doesn't appear to have happened to any significant level.

Instead of leaving the market altogether, many landlords have instead decided to incorporate, which has been the most significant direct impact of the phasing out. It seems unlikely this was the government of the time's original intention.

For those landlords entering the market now or considering expanding their portfolio, the question will be whether placing it in a limited company structure is more profitable – something that many wouldn't have been asking this time five years ago. That would appear to be the most significant legacy of what has and continues to be a highly controversial measure.

Enjoying our content?

Get the latest letting news, views and tips from HomeLet straight to your inbox.