L/O troubles- any help appreciated

I have done loads of L/O over the years, but I am having troubles with one in particular and could use some fresh ideas. Here is my scenario.

Went into L/O contract on Mar. 1, 2007. 3yr. lease. Appraised value as of Jan 10, 2007 was $680K. My purchase price set at $630K. Option fee of $4500 and monthlies set at $4600. My incoming rents are $4600. No purchase price credit from monthlies but seller gave me double my option fee as a credit.

Here is my dilemma: Property had a 3-2 and two studios down below. Rents with this setup would have been $4400-a negative $200/mo. for me. I saw that I could convert one of the studios into a 1 bd. with minimal investment. It cost about roughly $1K and took 10 days.
This got my rent set up at $4600/mo. No problem so far.

When my contractor converted for me he got permits and the whold nine yards. Inspector called it good and we were off- a new tenant with higher rent. About 1 month after the work is finished I get a letter from the water department wanting to know how many units I have. I tell them 3- big problem. They send me a letter saying even though the building dept. says no problem, they do not allow this setup in the neighborhood my rental is in. I try to work with them and they tell me the only way to resolve the problem is to go back to 2 units plus a extra living area.

I know that I have a lot of legal options here, but I am not sure which to take. I want to hold this prop. if possible, I stand to make a long term gain of well over $150K. My first instinct is to get my payments or price lowered.

Any fresh ideas would be appreciated. Thanks.

Unfortunately, it appears you’re going to need a variance from the zoning folks. Can it be done? Sure. But from experience I can tell you it isn’t a quick and easy process. And it may require the assistance of an attorney.
I think a bigger issue here is your doing a deal that has a very unfavorable risk to reward ratio. When I look at the numbers, I don’t see what’s in it for you. You paid retail, put down almost $5K for that privilege, and are facing a negative cash flow each month.