It should be the result of a deep conversation with a tax professional to understand the pros, cons, and risks.If you have a mortgage on the property, I agree that it opens a lot of tricky side effects that you need to mitigate.

It depends on the situation, the contractor and the market you are in, but generally, if this is someone you've worked with, you trust and they do decent work, I'd chalk it up to miscommunication, offer to split the difference as a peace offering and devise a plan to mitigate this in the future. 

I'm always curious how rehabbers mitigate homes like these.

@Scott Morongell thanks for your feedback, totally agree that scale can mitigate risk.

It's those maniacs that buy homes cash via quit claim deed off of craigslist that really get screwed.Make sure your property manager is a licensed real estate brokerage.Understand you can not eliminate all risk, only mitigate it.

Now, I need to know the exact usable space, wetland delineation, water & sewer hookup cost, mitigation banking, cleaning up the trees, construction cost as exact as possible.

I see your points, but it all depends on probabilities and mitigation. 

If you are willing to allow it, make the increase significant enough to mitigate the increased risk and provide a little proffit.

The below is pure speculation; I don't work in "loss mitigation" or have any insider scoop on it.With interest rates as low as they have been since 2012 or so, and given where appreciation has been, and the fact that when/if a home sells the title company will require that the lender (plus back interest) be paid off, it's possible that the 'rational' thing to do is let the interest accrue on the assumption/hope that there will still be equity in it at that point when someone dies/divorces/etc and sells. 

With that said, we can only put as much systems in place to mitigate against risks but nothing is 100% full proof.