Take the rate question second, because the note language changes what rate you actually need.
A contractor buyer with an $85k down payment on $425k is at 20% equity, which is real cushion. Your practical exposure isn't the whole $340k, it's the cost of getting the building back and the condition it's in when you do. Foreclosure timelines run from a couple of months in fast non-judicial states to well over a year in judicial ones, and during that window you're getting no payments, taxes may go unpaid, and deferred maintenance compounds. Price the rate against that number rather than against what a bank charges, because the bank has scale on recovery and you have one asset.
On the language, the clauses that matter for your specific buyer: a covenant requiring permits for any structural, electrical, plumbing, or mechanical work with lender consent above a dollar threshold, and default triggered by an uncured code violation or stop-work order. Insurance naming you as mortgagee with notice of cancellation, plus a requirement that any claim proceeds above a threshold get applied to repair or to the principal at your election. Annual proof of paid property taxes and, if you want teeth, escrow through a servicer. A due-on-sale or due-on-transfer clause covering transfers into an LLC or a land trust, or he moves title and you find out at payoff. Right to inspect the interior with notice, which standard residential forms often omit because banks don't bother. And an estoppel or annual financial reporting requirement if you plan to sell the note, because a buyer of the paper will want a payment history and a current condition report.
On your installment reporting concern, repossession does change how the gain gets handled and the mechanics are unpleasant. That's a question for your CPA before you sign, not after default. Get the answer in writing so you know what a year-three failure costs you in tax as well as in vacancy.
The balloon is the piece I'd stress-test hardest. At month 60 he has to refinance roughly $317k. If conventional lending is still tight then, your realistic choices are extend on your terms or foreclose on a performing borrower who simply can't find a bank. Decide now what extension you'd accept and put the framework in the note.
