Short answer: This situation is too complicated for do-it-yourself tax preparation.
From IRS Publication 537: A gift of an installment obligation is a disposition. Your gain or loss is the difference between your basis in the obligation and its FMV at the time you make the gift.
What does your father-in-law say about taxes? Generally, one of you needs to report it. If it was the sale of his primary residence, he most likely excluded the capital gain from his tax return in the year of the sale.
It sounds like your father-in-law has made an installment sale. If he excluded the gain, only the interest needs to be reported as income. If it was not the sale of his residence, then a portion of the capital gain needs to be reported each year.
You do not get to reduce the taxable income by the insurance and property tax paid. The insurance payments are not deductible. The property taxes are deductible as an itemized deduction.
