The loan must be done in a business-like manner with a written note specifying the loan amount, interest rate, term and collateral. IRS requires that the mortgage be a recorded lien to allow the interest deduction.
Sometimes, a friends and family situation might have a less than normal interest rate on the mortgage. However, the rate charged in the note is regulated by the minimum applicable federal rate which is published monthly by IRS based on current Treasury securities. For July 2017, the rate is 2.57% for terms over nine years.
The seller must report the interest paid to them along with the name, address and Social Security number on schedule B when the buyer uses the property as their principal residence. A mortgage between family and friends can be good for both parties. It may allow the borrower a slightly lower rate without the expenses of a traditional lender while giving the note holder a higher rate than they can earn in available investments.
Your tax professional can guide the transaction whether you’re a buyer or a seller and your real estate professional can help arrange to have the documents drawn and filed.