It's nearly impossible to buy a home without taking out a mortgage to pay for it. Though most people get their mortgages from banks, there's nothing in the Internal Revenue Code that prevents you from counting a loan from your parents as a mortgage -- as long as it meets the mortgage criteria.
Your loan from your parents can't just be an oral agreement that you'll eventually pay them back. Instead, the loan must be "secured debt" and your home must be the collateral. To be secured debt, you have to sign an actually agreement -- call it a mortgage, deed of trust, or land contract -- that defines your home as collateral and is recorded or perfected under the state and local laws that apply. If it's not recorded and perfected, it's not good enough for the Internal Revenue Service and won't qualify for the mortgage interest deduction.
Main or Second Home
The house also has to be your main or second home -- and if you're borrowing from your parents, chances are it is. See, the mortgage interest deduction is limited to just your primary home and one second home. For example, if you borrowed from your parents to buy a summer home, you can still deduct the interest even though it's not your main home.
You're limited to deducting the interest on the first $1 million of home acquisition debt -- money you borrowed to buy, construct or improve your house. If you borrowed money from your parents for something besides your home and you used your home as collateral, the debt counts as home equity debt, and you can only deduct the interest on the first $100,000. If you're married but file separate returns, the limits are halved for each spouse -- you can only deduct the interest on the first $500,000 for home acquisition debt and the first $50,000 for home equity debt.
When you have a mortgage with a commercial lender, you usually receive a Form 1098 at the end of the year. If your parents send you a 1098, your mortgage interest deduction goes on line 10 of Schedule A. However, chances are, your parents aren't going to be sending one. So, instead you report your interest paid on line 11 of Schedule A. If you bought the home from your parents, you must also list their names, address, and taxpayer ID numbers -- typically their Social Security numbers -- next to line 11.
Parents' Tax Consequences
If you're paying interest to your parents, they need to include the interest as taxable income on their return the same way they have to include interest income from their savings account. For example, say you pay $10,000 in mortgage interest and claim a $10,000 deduction. The IRS is going to be expecting that interest to show up on someone else's return as taxable income.
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