Legal Question in Real Estate Law in California

I'm sorry, you thought major repairs, renovation and conversion work to an existing structure didn't require permits? Really?

Well even if you are honestly and in good faith that clueless, AND your contractor didn't tell you, AND your realtor didn't tell you, you still are stuck with a mess. The fact that the buyers removed the loan contingency doesn't save you. There is no way you are going to win a fight with the buyers when you breached the statutory and common law disclosure obligations. The fact that it was negligent rather than intentional is irrelevant. They have a right to cancel even after the contingency was removed. Be glad this didnt' come to light after close of escrow. Then they'd be suing you.

Release their deposit, and then have a LONG talk with your listing agent and his/her supervising broker, if any, about why the hell they didn't go over the disclosures with you thoroughly enough that you would have known that non-permitted work meant ANY non-permitted work. The only person(s) who owe you any kind of explaination and maybe money is them.

It would be irresponsible for anyone to opine as to the validity of your position in this matter without reviewing the actual purchase agreement. As a general rule, however, financing often remains a contingency until escrow closes. As such, if the lender refuses to make the loan because of unpermitted work, then the buyer probably has a right to cancel the agreement, or extract a change in terms from you. Even if they lifted all contingencies, but then later discovered that you failed to disclose unpermitted work, they probably still have a right to terminate. The buyers are very likely not in breach, and so you are probably not entitled to retain their earnest money deposit. I guess I'm not clear how you thought that you could "replace" a structure as large as a garage without a permit - even many smaller termite repairs require permits, as they involve structural work. Did you have an agent representing you in the transaction? If so, they should have advised you to disclose the unpermitted repairs.

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On a more positive note, maybe you can bring the unpermitted work into compliance, at a net gain in market value. I'd enlist the aid of a local lawyer with significant experience in permit issues AND a licensed contractor who can give you estimates and quotes to do the required work. Some jurisdictions are more lenient than others, and there are occasional amnesty programs here and there. I suspect San Diego is pretty strict, especially in the more built-up areas, but rather than assume you're stuck with a hard-to-sell lemon, see what your prospects are - what the "sugar" would cost to make lemonade. Maybe you can get a $60,000 detriment removed for an investment of half that, or less.