Insurance (homeowners and umbrella) is good to have, but a backup to this if insurance coverage was denied or the issue was not fully covered would be a limited liability vehicle.

The issue comes with test 2.

Cap rate is ~15%, but we want to build a portfolio as we continue learning so we are trying to get our cash back out.Our key issue is that we purchased the home and did the rehab in cash, and we are now struggling to find methods to get our cash back out.

On top of that I've been dealing with an issue of who's at fault for major damage that originally occurred due to their shoddy management and maintenance.

The code enforcement officer said he mentioned these issues to the sellers and the sellers' agent.

So legally, you can say 'no' to many of the issues that are brought up during an inspection.

Does anyone see any issues with doing it this way?

Overall, he did a good job, but there are issues that will show up on an inspection that aren't necessarily liabilities.  

The issue you are going to run into if your lender hasn't told you already having the 3.5% is only part of the equation.  

It unlikely calls for a closing/sale without substantial completion, and the bank shouldn't have an issue with funding with a typical "punch list",  perhaps holding back a few grand.