In order for the borrower to deduct the interest on the loan, the loan has to be secured by the home and the mortgage has to be recorded by the appropriate state or local government agency. If that was not done, the loan is not a true mortgage. In that case the interest is not deductible so the borrower does not report the interest or anything else about the loan on his or her tax return.
If the loan is properly secured and recorded, since there is no Form 1098, the borrower enters the deductible amount of interest on Schedule A line 8b in their tax return. Line 8b is specifically for "Home mortgage interest not reported to you on Form 1098." The borrower should refer to "Part II. Limits on Home Mortgage Interest Deduction" beginning on page 9 of IRS Publication 936 to see if the amount they can deduct is limited. They should also look at the definition of Secured Debt in Publication 936.
You have to report the full amount of interest income on Schedule B even if the borrower cannot deduct it or cannot deduct the full amount. It's interest income to you, whether or not it's deductible mortgage interest for the borrower.
