Home We're Buying Has Illegal In-Law Cottage—What Are the Risks?

Dealing with insurance, tax, and other issues that could come of trying to use or rent out an illegally constructed unit.

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During your house hunting, you might come across properties with outbuildings such as a shed or in-law unit. These can be cute, and the extra space might be perfect for housing out-of-town visitors or short-term renters on one of the "sharing" sites. Unfortunately, it's not uncommon for such structures to have been built without the required building permits. The seller's materials might even disclose up front that it's "illegal." What does this mean? Should you go forward with our offer? That's what we'll discuss here. (Also see Nolo's articles on Airbnb and Other Short-Term Rentals of Your Home.)

• Why Illegal Construction Is Problematic for New Homeowners
• Should You Walk Away From the Home Purchase, or Negotiate With the Real Estate Seller?

Why Illegal Construction Is Problematic for New Homeowners

A number of issues commonly arise with illegal construction, such as:

• Inferior and/or unsafe construction. A permit is required to ensure safe and quality construction. Without a permit, there's no guarantee that the in-law unit was constructed well. It might have been a DIY by an amateur.
• Expense and hassle of bringing property up to code. If the city (or governing municipality) finds out about the illegal unit, it will require you, as the new owner, to bring it up to current code and obtain the required permits. The city does not care that you weren't responsible for the original construction. Obtaining a permit after construction has been completed can be a lengthy and costly process, and could require tearing up existing walls and so forth. See Discovering Unpermitted Construction When Selling Your Home for more information.
• Financing challenges. Your financial institution might not be willing to extend loan financing on a house that includes unpermitted construction. After all, it's counting on your property serving as collateral if you default (fail to pay) and it therefore forecloses on you. Unpermitted construction makes the property worth less than it would have been if everything had been done legally.
• Insurance limits. If a fire or other incident occurs in the in-law unit or shed for which you might pursue an insurance claim, your insurance company could deny coverage. You likely will not have trouble initially obtaining the policy, but beware of the small print that excludes coverage for construction not built to code standards or built with inferior construction. And if you decide to rent the space out, be sure to read Insurance Questions When Renting Out Your Home Short Term; your homeowner's coverage might not be as extensive as you'd expect if you're running a "business" in your home, leaving you potentially liable if a guest is injured.
• Retroactive tax obligations. If your local taxing authority has not been assessing real estate tax on your in-law unit because it wasn't a recognized part of the property, you might become responsible for paying back taxes.
• Obligation to disclose issues to future home buyers. When you eventually sell the property, you will be required, by law, to disclose the unpermitted construction (assuming you haven't since brought it up to code) to potential buyers. (See Required Disclosures When Selling U.S. Real Estate.) This will make it harder for you to sell the property for the price it would otherwise be worth.

Should You Walk Away From the Home Purchase, or Negotiate With the Real Estate Seller?

If you decide that purchasing a house with unpermitted construction is not worth the risk, you can walk away, assuming you're not too deep into the closing process by now.

Another option is to negotiate to have the seller obtain required permits prior to sale. This might be a good solution if you are willing to be flexible with the closing date. (The permitting process can be lengthy and unpredictable, so think in terms of months, not weeks.)

If you do choose to go forward with the home purchase, consider the terms of your offer carefully. The property might well be worth less than its list price. For example, the market value of a two-bedroom house with an illegal in-law unit is actually closer to that of a two-bedroom house without the extra unit.