In the NYC area where I am, it’s a common sitiuation, a SFH with an illegal “inlaw” unit in the attic or basement, or even more common, a 2-family with an illegal 3rd unit.
It’s so common here that former Mayor Koch was asked why he doesn’t crack down on such practices and his answer was “they’ll be 200,000 or more people homeless living on the sidewalks if I cracked down”.
Insurers and banks here go on the bases of the “certificate of occupancy”. So appraisals are done on a 2-family with a 3rd as a 2-family, not a 3-family, and insured as a 2 family. I had properties of this type, and had them mortgaged and insured.
Lately, with fires in some illegal units causing death and serious injuries, the city cracking down on them with criminal penalties, banks and insurers will not lend or insure a property where the illegal unit does not have “two egresses”. They don’t want to get into trouble with these. An illegal unit with only ONE egress will not be financed or insured till it’s removed.
The small problem with a SFH with an illegal “inlaw” unit is you don’t get any liability coverage for tenants, so if a tenant trips and falls, your not covered since the unit is not supposed to be there.
The bigger issue is “evictions”. An example is a 2 family with an illegal third, where units A&B are legal and unit C is not. Unit A does not pay rent, landlord starts eviction, and a sharp legal aid attorney would first check the CO, find three units in a legal 2-family. Here in NYC, when you go to court to evict “tenant A”, the judge will tell you to evict illegal “tenant C” first, throws out your case because you have no standing, and "come back when you’re in total compliance with the law. On top of that, in some jurisdictions, such as NYC, you’re not entitled to the rent on the illegal unit, and you’ll have to refund it.
Now you’re stuck with one tenant not paying, while evicting a paying tenant, and liable for a year’s refund!!.
One “wiseguy” rented an illegal basement from my mother in law’s friend, an elderly lady, both Chinese immigrants. The young man paid in cash and told the elderly landlady that the advantage is she doesn’t have to report the rent on her income taxes. A year went by and he confirmed that she didn’t report the income by asking “isn’t it nice that you saved on your taxes??”, and she nodded yes.
Then, one day, he told her that she’s in big trouble, that she has to refund the rent paid, and allow him to live another year rent free. Reason is he can have a judge order a refund for the illegal unit. And he will report her for cheating on her income taxes to the IRS, and even entitled for a bonus under the law. The elderly landlady may even have overcollected on her Social Security.
What a creative way to live rent free for TWO years!!
So I’m careful, and whenever a tenant volunteers to pay cash to cheat the taxman, especially those renting illegal units, I insist on “money orders”, not cash, because I tell them "I report every penny to the authorities. Also better that tenants know my pocket is full of checks and money orders, NOT CASH, when I make my collection rounds.