All of this comes with the understanding, I will be brought in and tough the process with the intent of venturing out on my own. 

There may have been things that were done that your father didn’t like but nothing that was done was illegal, immoral or unethical and definitely not done with intent.

andDo you file a police report, if you have no intention of turning it into insurance and value is not that much?

I probably would have called them myself but my Primary Attorney also another investor I am scheduled to see on Monday .to review all intents at this time .Unlike some Investors I am more comfortable having legal representation on my part for all my Investments be they LLC's Trusts , Probate Matters etc; Particularly if seller is based out of state . 

@Rick RapantIt's unclear from your post if the seller intents to retain the deficiency judgment. 

Depending on what your thoughts , wishes, intentions or desires are for the use of the land you have to make sure you will be able to use the land for what you want.

Thats like our proof for being a Veteran and on some occasion i have got away on 1-2 tickets but that was not my intention to use it that way, i just happen to open my wallet and the officer just happen to see it and let me go.

My intentions with the cash flow from house #1 is to keep it all (minus vacancies/repairs etc) and snowball it into a larger chunk to help purchase house #3 (remember, I'll be living in house #2 and fixing it up as I go) but I'm still a bit confused as to how to prepare for and handle the transition into a second house before I have a tenant for the first house (I'm sure the bank will want to see that I either have a tenant, or reserves to cover the first loan until I get a tenant).. 

Like we did with the rest of the house we spent serious money renovating and improving the addition,   with the intentions to rent it as a separate unit with separate entrance while we lived in the original 3/2 floor plan.Where the issues lies, the kitchen in the granny flat is unpermitted the lot is zoned for SFR, there is a handful of other unpermitted, not to current code or plan issues throughout the 60 y.o. house, mostly before the purchased the home. 

If you wish to do this you will need to submit a letter of intent with your next rental payment.