I see two issues in your letter: First, protecting your rights if your child stops paying the second mortgage; and second, dealing with the tax implications of becoming your child’s banker.
Generally speaking, private mortgages are offered to people with no or low credit rating. The interest rate on a private mortgage is higher than a conventional bank mortgage. Private mortgages are sometimes called “hard money” mortgages.
In your case, you are acting like a hard money lender, but because your child is the borrower you are not offering a hard-money rate.
Whether you are offering a private mortgage/hard money loan to a relative or a stranger down the street, your issues are the same. You need to protect your interest if the borrower fails to repay the loan. It is likely your child has the best of intentions to pay the loan. However, unforeseen events occur. What are your rights if your child becomes unemployed and cannot repay you? Where will you stand if your child dies unexpectedly? Or if your child is married and becomes divorced? Or if your child is single today gets married? Or sells the property? In a nutshell, you need to answer the question, “If I lend the money, what are my rights?”
A form will not answer your needs. You need a contract with your child that spells out your rights and your child’s liabilities. You need to decide if you will have an interest in the property — in other words, a lien. Consult with an attorney in your state who has experience in contracts law or real property.
You mentioned the federal tax deduction for mortgage interest. This is provided on the IRS form 1098 that the lender must provide to the borrower. In your case, you would need to complete a 1098, give it to your child before January 15 of each year. Your child, or any other borrower wanting the mortgage interest deduction, would file this with their form 1040 tax return.
It is likely that if you create a 1098 and your child files it, the IRS will audit your return to make sure you are declaring the interest income and paying taxes on that income. This is no reason not to create and give a 1098 to your borrower, but you must be aware that the 1098 creates a nice audit trail for the IRS to follow.
As mentioned earlier, consult with an attorney to draft a contract before you lend you child the money. If you do not, you should be pleasantly surprised if the debt is repaid, but set an unspoken expectation to yourself that the money lent is actually a gift.
I hope this information helps you Find. Learn & Save.