Basically I just want to be able to have walk away money of what we are paying in case of a total loss along with only having claims that would be above the $10,000 threshold and above.

It is always better to keep a tenant than to try to evict one - unless of course you are losing so much money that the vacancy loss is better than what you currently are getting - but this does not seem to be the case in your situation. 

I'm no tax guy  but passive 'losses' can only offset earned income if you're a RE professional as far as I know.  

Outside taps are another loss.

I would say only the most experienced investors (talking accredited here that can afford a complete loss) should be in this game and only if their emotional makeup can tolerate it.  

I have seen on this website answers both ways regarding this (the site administrator saying leave it in Sch A, and his colleague (also a enrolled agent) advising that it can be written off in Sch E, but that there are certain restrictions mainly -- you must have passive activity gains where the deductions are covered (no passive activity loss carry over allowed. 

It's ok to work at a loss or break even, if you make it up in volume.

You have zero equity the moment you start, and zero equity when you get to the balloon payment.You are simply delaying the day of reckoning when you have to buy the property for a short term gain in cash flow and tax loss.

If the last two years of tax return show a net loss (because of depreciation etc), does anyone know how it impacts this calculation?

I can't be the first person that's done this for sure.I have an LLC setup with partner(s) with all the very specific terms in our operating agreement (Ownership Percentages, profit/loss, who's responsible for what initial costs, etc.)