They all threatened lawsuits, naturally.

Especially about lawsuits and the summons process.Read AZ law carefully about the requirements for damage deposit and follow them to the letter.IF she sues you, so what.

If you fail to follow the rules, you may open your personal assets to a lawsuit.

The risk of triggering this is remote, as investors here are happy to debate, but so is the risk of a lawsuit that would result in substantial damages that an LLC could prevent. 

I have built a lot of apartments that could be converted, but many are never converted as the areas they were built are also very condo friendly and developers do not want to deal with headaches of associations and lawsuits.

I am currently putting an in-law suite addition on the house and using a home equity loan to do the reno; my question is should I pull out an additional 36k from our equity to repay the 401k?

If all are under one then they can all be tied together in a lawsuit but if you have them in separate LLCs then they have the chance of not being tied together. 

Obviously we'll section off the area prior to construction, but I'm concerned about the safety (and lawsuits) for all involved.

At the end of the day, nobody knows what will occur in the future, and because nobody knows, your financial models need to be able to withstand worst-case scenarios (for instance, market downturns, significant vacancy, huge capex, significant wage increases for personnel, tenant lawsuits, etc.)...and $2,700/month cashflow isn't close to being enough to offset the work and the risk of 40+ units...Sorry to be the bearer of bad news, but the good news is: there are always other deals to be found, and there are always other opportunities for success in RE (if you put in the work).Good luck out there!

I would guess if you didn’t share and the issue resulted in a lawsuit, not providing the lease would be an automatic strike against you and the judge would lean in favor of the tenant.