Inserting newlines in Rectangle Text elements via ArcPy causes overlap?

I ran into this as well. It's because ArcGIS requires Windows line endings which are both a carriage return and a line feed. Bit of a pain. Fortunately it's easy to get around. In Python by instead of just \n (which is linefeed - see the Python docs for more if you're keen), use \r\n.

I think it is easier to use the textwrap module:

Python label expression:

def FindLabel ( [LEGAL1]  ):
  import textwrap
  return '\r\n'.join(textwrap.wrap([LEGAL1], 20)) #charcter width set at 20

And the resulting labels have carriage returns split at whatever character width you chose.