“1) Have we got everything covered for this to be a legitimate transaction in the eyes of the IRS? If not, what are we missing?”--->As you said,” Mom gave us a $12,500 check and dad gave us another $12,500 check as gifts,”, each of your parents gave you $12,500 less than $13,000; $13,000, annual gift tax exemption amount,> $12,500, so,your parents do not need to file the form 709. As long as the long term interest rate( 25 year loan as you said), 3.25%, is higher( or as high as IRS long term AFR, applicable federal rate), the IRS may not impute interest. What Imean is that for a loan made at low interest rate(as long as long term AFR, 4.19%>long term interest rate, 3.25%), the IRS may impute interest. This means that your parents, as lenders of the loan, must recognize interest income equal to the imputed interest, and you, as borrowers, have an implied interest payment to the lender. To impute the interest the IRS uses the AFR, compounded semiannually. The difference between the interest using the AFR and the interest actually paid on the loan is the amount of imputed interest. The current IRS LT AFR is 4.19% and your loan rate is 3.255, then the IRS ‘d impute interest,0.94%;4.19%-3.25%.However, for reference no interest is imputed on a gift loan( I mean a loan from parents to you) of $100,000 or less if the borrower’s net investment income for the year doesn’t exceed $1,000.
“2) Would my husband and I be able to deduct the interest on this loan? If so, what else do we need to do to make sure we can do this? What would my parents need to do on their end? ...or are we better off not reporting anything at all???”--->As said above, as long as the IRS imputes the interest, the difference between the interest using the IRS LTAFR and the interest you actually pay on the loan is the amount of the imputed interest, you can deduct it on 1040 Sch A line 10; your parents report the imputed interest in their gross income.
“3) Does anyone have any better suggestions as to how to best handle this personal loan?”-->As said above.
“4) On top of this, we plan on renting our current home to my mother-in-law at a greatly discounted rate using a basic rental agreement. Not sure if this changes anything or not, but wanted to mention it nonetheless.”-->I do not think so UNLESS the loan proceeds are used to purchase income producing property ,i.e., stocks and bonds, and similar property; the fact that you plan on renting your current home to your mother-in-law at a greatly discounted rate using a basic rental agreement is a sort of , I guess, a gift; as long as the the difference of rental rate between fair market rent rate and your rate may be regarded as a gift, and if the amount exceeds $26,000( $13,000 for you and another $13,000 for your spouse or under split gift situation), then you need to file Form 709. However, as long as the loan proceeds are used to buy income producing property(assets), as said above, then interest needs to be imputed on gift loans of $125,000.