All interest is deductible.
Assume no principal payments on 1 st mortgage. If both immediately sold properties before any change in value, neither would recognize further gain. Under section 121, however, gain is entire excludable, since she lived in house for at least 2 or last 5 years, regardless of whether she purchases a replacement home or rents. Unrecognized gain is not deferred but is completely forgiven. Also note that reimbursement of personal living expenses is excludable under 123.