Quote from @Landon Mizuguchi: @Michael Plaks if you're living in the house and renting rooms  (e.g. room hacking) you can't claim losses?  

Offset Gains with Capital Losses: If you have other investments that are currently at a loss, selling them can offset the gains from your property sale, reducing your taxable income.5.

Two weeks later I stopped by the unit (was passing by and decided to take a look) and found that someone was using the shower and leaving food and clothes in the house with visible intent to return.

Some carriers offer loss assessment insurance, which can come into play when the HOA experiences a large covered insurance loss, such as a hail storm requiring roof replacement or a fire requiring building replacement.  

I figure my options are to sell and take a loss (not ideal), or preferably find coverage that allows or doesn't care about the K&T.

We're at a loss on what to do here.

These self employed 2nd mtg's are typically based on alternative method of caluclation like profit and loss statements if you're self employed or the last 12 months of bank statement deposits using a formula to derive an income from these deposits (like 50% of all annual rolling 12 calendar month deposits X 50% /12 months = monthly income).

Would you prefer they change their policies just to fill your rental quicker and then increase your risk of losses?

You could lease part for food service or coffee shop and some retail space, a small health club, massage. 

Or the market tanks and the value of the house goes down and that creates issues (selling at a loss, who brings money to the closing table, etc.