Our rental criteria states "No outstanding debt in excess of $1000 that is not in a payment plan."

If the out going tenant puts multiple holes into the walls and therefore makes the property un-rent-able  until the holes are fixed, is the out going tenant responsible for the loss in rent income ( 1 month) and can i...

We paid much more on what was owed on the second lien and the question is why the excess proceeds is not going toward paying the senior mortgage?

Usually the fines are for "Noxious Odors in common areas" or for excessive noise.  

Personally, I am planning a strategy of only repairing areas where the peeling is excessive i.e. the guest bathroom and guest bedroom.

That means you'll have to talk to some lenders that do that type of thing to see if they have an appetite for the property and your specific situation.  

The appetite for risk is varied from investor to investor, of course. 

IF for security that generally covers excessive damage.

They use the cash flow from each property to pay for itself then the excess is used to pay themselves. 

If you used the FMV at the time of conversion to rental use to determine your depreciation, then you will also have excess depreciation to deal with which will be taxed as ordinary income.