Is our purchasing contract void due to a Illegal In-law apt.

[Dominic R.]

A little background on our situation. We found a nice 2,400 sf. 3 bedroom and 2.5 bath Cape in a B+ neighborhood in a A+ town. The house was in great shape and the price was reasonable. One problem was that the second floor had been turned into a really nice but illegal in-law apartment. Our plans were to buy the house, remove the upstairs kitchen and convert the second floor into 3 bedrooms and rent it out as a 5 Bed 2.5 bath SFH. About 10K to do the work. Our PM looked at it and said we would be able to easily get 2.5K to 3K in rent due to the area. We put in an offer and eventually came to sign a contract for a cash purchase. We scheduled an inspection and found some code violations with the electric panel in the apt. We then went to the townhall and pulled the assessment and found that they had discovered the apt. in 2005 and added it to the records. We then went to pull the building records and then found out the building department didn't even know there was a finished second floor. The building official said it was no big deal and he would work with us after we bought the house. Now since the assessor and the building department records don't agree our PMs lawyer says it would be impossible to get title insurance. So we informed the seller that we need a extension so they can clean this up before we or anyone can purchase it. Their agent agrees and we are waiting the sellers reply.

So here is the question.  My wife believes that they need to pull the permits and bring the second floor to code and sell us the house since it is under contract.  My belief is that the contract is now void and they can pull the permits to convert the apt to bed rooms, fix the electric and put the house back up for sale at a much higher price.  I personally hope my wife is right since I really want this house at this price.  So where do we stand.