Structuring Intrafamily Mortgages for Deductibility

When parents or grandparents wish to assist the next generation with home purchases, lending the funds via an intrafamily mortgage is often financially superior to a cash gift or a commercial mortgage. It keeps the interest yield within the family ecosystem and gives the borrower access to capital at the Applicable Federal Rate (AFR), which is typically lower than commercial retail mortgage rates.

However, a common trap is failing to structure the loan so that the borrower can deduct the mortgage interest. Under IRC §163(h)(3) and Treas. Reg. §1.163-10T, for mortgage interest to be deductible as qualified residence interest, the debt must be secured debt. Under tax law, this means the loan must meet three conditions:

1.

It must be documented by a legally binding promissory note under state law.

2.

The debt must be secured by a recorded mortgage, deed of trust, or land contract that makes the borrower’s interest in the real property specific security for the debt.

3.

The security instrument must be formally recorded in accordance with state or local law (such as at the county recorder’s office) within a reasonable time.

If a parent lends a child $500,000 to buy a primary residence and they execute only a promissory note without recording the security interest in the county registry, the loan remains unsecured. Even if the child pays interest to the parents at the long-term AFR and the parents report it as taxable interest income, the child is legally barred from claiming the interest deduction.

Get the reporting mechanics right, because the common advice here is wrong in both directions. Form 1098 (Mortgage Interest Statement) is required only of a payee engaged in the trade or business of lending; a parent making a one-off family mortgage is not, and generally has no obligation to file one. Nothing is lost by that. The child still deducts the interest by reporting it on Schedule A as interest not reported on a Form 1098, which requires naming the lender and supplying the lender’s address and taxpayer identification number — so the parents’ Social Security number goes on the child’s return, and the parents must report the interest as ordinary income on Schedule B. A missing or mismatched TIN is the single most common way these deductions get disallowed. For families using these strategies, specialized service providers (such as National Family Mortgage) can manage the drafting, recording, and tax-reporting administration to ensure compliance with the complex state-level recording rules and federal tax laws.