Rental with unpermitted basement space?

[Matthew Porcelli]

I have somewhat of an oddball question/situation to pose. I own a home and occupy the upstairs (3 beds and 1 bath) and unfinished portion of the basement. I have a finished portion of the basement which I rent out as a 1/1. This space is considered an illegal apartment because it is not permitted and according to my understanding cannot be permitted due to ceiling height and lack of egress windows. There is access to "my space" via a door which I keep unlocked in the event of an emergency. 

I will eventually move out and would like to keep this house as a rental. 

My questions are: 

Can I maintain the illegal basement apartment and also rent out the space that I am using and do it legally, with lease protections, and treat it as an investment property in the eyes of the IRS/banks (for DTI purposes)?

Or should I rent out the entire house as a 3/2 with a finished basement/bonus room?

Or just sell and use equity (approx 200k) to buy myself another home and a Section 8 rental?

My main goals are protection from liability in case something happens while I am renting this home (if I can), legally reporting income so I can maintain a healthy DTI, while making the most of the equity I have.

I can probably get $2800 monthly for a 3/1 and am currently getting $1550 for the 1/1 for a total of $4350 (I would have to pay electric and water, assuming $300/mo).

I can likely rent whole house for $3000 and the tenants will pay their own utilities. 

My monthly mortgage with my current homeowner's insurance is $2200/mo. I know the insurance would be different as a rental.