Investment losses on rental real estate are limited to $25,000 per year, unless the taxpayer is a material participant in the management of the property (which is almost never the case under IRS regulations, unless the taxpayer manages rental properties full time).
If you treat the property as rental property, then you will have a taxable capital gain on sale (assuming the tax laws remain consistent). However, if you reside in the property as your principal residence for two of the last 5 years before sale, then you can exclude your capital gain up to $250,000 ($500,000 if married). Of course, you can't treat the property as a rental and claim it as your principal residence simultaneously. But, you could wait until two years before sale, move into the property and then sell.
Note: I neglected to mention that currently, the maximum annual gift that does not require reporting to the IRS, and does not trigger a gift tax liability, is $13,000 ($26,000 if married). So, if fair market rent for the property is more than that, then you could have a problem, because during an audit, if the IRS were to get wind of the fact that you are routinely gifting back the rent to the tenant, then the IRS could declare the entire deal an abusive tax shelter, and cancel your rental deductions.
Hope this helps.
Edited by socrateaser on 9/3/2010 at 4:29 PM EST