I have friends: A, B and C. Friend A bought a home for each friend B and C, with a non occupant mortgage on each property. The purpose was to help B and C achieve home ownership with the understanding that within 5 years, B & C would each secure a mortgage and cash out the 20% down payment that A made on each property. B & C write a check each month to A for the exact amount of the house payments, and A pays the mortgages, to insure that thy are paid on time. A does not show the properties on his taxes, nor does he take any deduction for interest or property taxes. B claims that he has availed himself of these deductions, been audited by IRS and been given a green light. C, on my advice, and that of his tax person is not doing this. My understanding of the IRS tax code is that if the taxpayer is not legaly obligated on the mortgage, he cannot take the interest deduction; and the same would be true for the property taxes. Am I giving my friend C bad advice?

No, your advice is accurate for C.

The IRS audit on B was bungled, because they never noticed or determined that B did not have the legal obligation to pay and therefore could not LEGALLY claim the deduction.

What you have here is a rental situation. A is the landlord and should be showing these properties as rental properties. His failure to do show does not change the fact that, when B and C buy the houses from him, the sale must be recorded as Business Property sales on Form 4797. Further, the depreciation on the houses must be redacted from the basis when determining the capital gains on the sale, whether A claims the depreciation or not.