Negatives are that there is an additional cost for me and if the tenant doesn't pay the water bill, i would end up with a potentially large bill at some point. 

Your monthly mortgage will be about 2,000, which won't pay the bills as a long term rental.

Her sister has agreed to us paying out her portion of the equity and having us use this as a rental. 

Now you need to figure out how to find deals and pay for them.

Matthew,Yes, you would want to use those funds and do a 1031 exchange to avoid paying taxes on the cash or (boot) from the sale of the home. 

I'm assuming the insurance company wants to pay put the least amount possible.

My understanding is that it is me paying out of pocket what the previous owner has put into the house.

Here in Florida, our most common contract states:"Buyer will pay cash for the purchase of the Property at Closing.

If our agent pays him via checks and bills us at closing, does this have any +ve or -ve impact on the taxes? 

The difference is that on the 2k house you can pay for that HVAC relatively quickly, where as the 800 house it takes many months to offset the costs.The same can be said for other costs such as property management.