However, I believe i need to wait until i rent the property for those improvements to be tax deductible - is that correct?

This means they can be deducted from the landlord's other nonpassive income, even though $75,000 of the debt was cancelled by the lender.

I have heard that paying off your rental is not necessarily the best choice because of the deductions it allows for, but given the type of loan this house is mortgaged with, is it even possible to buy another home together and start renting this one out when I have a FHA loan on this one?

You'll have costs that are deducted from that number, so let's say you walk away with $100k.

One is a passenger and gets no deduction.

Hi as Steve and Jason pointed out it is very important to keep funds seperate.You will need an escrow account, if it's required by law, your account will need to be titled XYZ ESCROW ACCOUNT, if not so required, it can be any account but ONLY deposits and funds held in trust should ever be depoisited to this account and any withdrawl should be well noted on the check and on your books.If you comingle you accounts and you need paper towels to clean units, the IRS can simply disallow your deduction saying it was used at home since it was paid from a personal account or one of comingled funds.I too would suggest you formalize a business entity, an LLC probably.

All of your living expenses are now deductible.  

But she wanted to know if she can deduct the principal amount that she paid to the person off of her taxes since she has to report the interest as income. 

Quote from @Levi Herman: why is that?

You can deduct real estate losses against W-2 income provided your modified adjusted gross income (MAGI) is under $150,000.