I think even if you were getting $650 per unit  you're still well under the 2% rule.

You should absolutely have your own leases in force and then you can set the rules to what you want (i.e. they pay their own water bill going forward). 

Section 1031 does not apply to exchanges of: Inventory or stock in tradeStocks, bonds, or notesOther securities or debtPartnership interestsCertificates of trusthttps://www.irs.gov/newsroom/like-kind-exchanges-under-irc-code-section-1031

I may have broken the cardinal rule by purchasing a multifamily mixed use commercial/residential property in Michigan that has shared utilities AND electric heat.

Pretty standard, forget about the 1% rule here.

In your case, this would apply. 

We purchased a duplex in a beach community that needed rehabbing(one half had been demoed to studs) after purchasing and applying for permits we find that fema limits the rehab to 50% of the apparaised value of the house.

The City of Boston has a rule wherein no more than four unrelated people can live in a unit...

Would the play then be to pay for everything cash and later apply for a LOC on the new appriased value?

I am looking to use some of my own cash plus hard money for my next deal, but how do I show proof of funds to get the deal under contract if I have to have it under contract to apply for the hard money?