@Julie Tohthe insurance issue I haven't explored but scares me in the event should a catastrophic event occur than called on the insurance when a person has an illegal suite. 

As you've fully stated the matter, I would have the professional company mitigate the issue, and have this expense covered in full by the seller - in exchange for not seeking legal action and not filing a complaint with the Real Estate Commission on the agent.That said, I'm also a believer in "Extreme Ownership" - in that all issues that occur in my business are ultimately my fault, and so I need to determined how I allowed this problem to occur.

What laws could stop this from occurring?

If that appreciation occurred while you lived there, your investment returns as a rental have to cover the lost tax benefits before realizing any investment profit.Whether to keep or sell has more to do with your predictable future appreciation than anything. 

Before seattle changed its rules and I hired a property manager,   I used language in my qualifying criteria to basically say that if a criminal record was present it must not reflect a pattern of repeated infractions,  must not have been for any violent crime or type of crime likely to impact landlord property, other tenants, or the landlord;   any not yet completed incarceration, parole, restitution, etc must not present an obstacle to paying rent and maintaining compliance with rental agreement, and there must be evidence of stability/mitigation, e.g. gainful employment, attending school, or some other constructive activity occurring after the conviction.But again, might be good to consult with attorney OR work with a local snohomish county property manager or landlord group who know better what is going on there.Again I would also seriously consider having floor on credit score.   

The increase rent was ostensibly for potential damage caused by the dog which may have still occurred however their argument is that the dog can't cause any further damage and therefore the damage will be limited.

What laws could stop this from occurring?

However, as you probably know, if you get a bank mortgage, the bank generally likes to make sure taxes are paid so a tax foreclosure doesn't occur.

The garage is in the alley behind it, no one actually knows who or when the damage occurred.

you will also need to complete and affidavit that you have no outstanding tax balances that are past due, know how you plan to take title, and prepare to pay the remaining balance within 10 days of the courts confirmation of the sale, this can occur as soon as about 10 days after sale to several months after sale, so be ready for possible delays in possession,   I had one that took 3 months to confirm. and I have others happen in about a week.