It you think you can re-rent it in three months, then let her pay 4 or 5 months rent to buy out of it, with part of that being a credit for the security deposit money, assuming there are no damage deductions. 

My deductible is high, around $4,200.I'm confused about whether I should try to keep the costs under budget and avoid using my insurance.

But if I put 0 for the state tax, my follow up question is how should I report this passive loss to NC which may be used to deduct future passive income.If you know any detail tax instruction for NC state that can help with case that would be also very helpful!

Expense Deductions: Deduct direct expenses like materials, labor, and selling costs.4.

The interest paid on a HELOC may be deductible if you used the funds to "buy, build, or substantially improve" the first home. 

With a sellout of $1.3million, deducting the closing costs and hard money lending interests these people typically have. the builder will be left with about $80K profit.

You don’t get any extra interest deductions, and you’ll likely just refi down the line to access the equity.

Quote from @Chi Zhang: I've spoken to my CPA about this and he said it is extremely hard to meet the qualifications, and most investors have enough deductions that this deduction isn't worth trying to achieve.

Insurance would cover it, I would pay the deductible, and no assets would be lost.If you are in an area like San Diego where people are more likely to sue, a judge is more likely to find you guilty, and the payout is expected to be higher, you may consider an umbrella insurance policy.

Also, I am involved in rehab and management, so I am claiming my STR income under the Schedule C.Why aren't you guys claiming it under Schedule C and getting the deduction?