Will the capital gains in this scenario be considered passive income from an IRS perspective ?

Your profile mentions that you are an agent with rentals.You would want to see if you are able to claim real estate professional status.If you are able to claim real estate professional status, you can potentially offset the rental losses with your real estate agent income.Furthermore, TN does not have a state income tax allowing you to be more open with your options.Best of luck

Quote from @Fadil Khan: Interested in learning about investing in property for rental income, commercial property vs rental properties (section 8, traditional etc)1.

I'm considering converting the shed into a DADU to maximize the use of the space and earn some extra income. 

A lot depends on your credit score, income, and the specific lender.

No income should be part of this underwriting

In the cities the government got involved in housing and low income housing was built for poor people.

@Joy McQuearyRecommend you first figure out the property Class you want to invest in, THEN figure out the corresponding location to invest in.Property Class will typically dictate the Class of tenant you get, which greatly IMPACTS rental income stability and property maintenance/damage by tenants.If you apply Class A assumptions to a Class B or C purchase, your expectations won’t be met and it may be a financial disaster.If you buy/renovate a property in Class D area to Class A standards, what quality of tenant will you get?

As Marshall said we will need to know breakdown between residential and commercial, exact business types, and square footage + income breakdown for residential and commercial units.

It's all income driven.