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Can I just sell the house (with the squatters) to someone local that feels like dealing with it?

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In the other hand, we do not feel comfortable buying this home anymore, our goal is to back out without paying a penalty of 2% of the sale price, and of course they are going to try and fight that expense.

This goes back to the size and layout of the house—A big house will feel less messy and cluttered than a small house.

You could offer them 1/2 or whatever ratio you feel is fair given the circumstances and they can write you a check for that amount to walk away.Another thought, if there is a way you can find out where they are moving, a forwarding address etc, I'd reach out to that new LL or owner and explain the situation to them, I have a feeling the tenant didn't disclose that they have an existing lease as a liability in their financials when the applied, and there may be some application fraud etc at play here that the new LL would likely want to know.Think about this from your own point of view, I doubt if you picked up and left one of your subway locations that the the LL would just let you leave.