You need a closet and a window to make it a legal bedroom, so start with that, also taking down paneling I've found to be totally worth it, it won't be too expensive either because you don't need to take down the entire wall just take off the paneling. 

Features: corian counter tops, hard wood maple cabinets, a 9" wide distressed pine plank flooring, 4/12 roof pitch, master bath with corner jacuzzi tub and separate shower, walk in closets, can lighting, open floor plan, stainless steel appliances, etc.

I think a nice renovation with a couple items that make you stand out (master closet, entertainment centric kitchen) would be beneficial.  

I actually had to evict a tenant who was using one of the bedrooms as her garbage dump/closet.

Big spacious home-tiny dining room with closet?

The "portable" or Micro units that Trachte makes would likely get you past any setback issues but they will cost a bit more...probably $300,000 for the same square footage.

Part of the patio will become a walk in closet.  

The work included:-- Fully remodeling the kitchen and two existing bathrooms-- Opening up the choppy main floor to eliminate a narrow hallway and expose the kitchen to the dining room-- Adding back a half bath that had previously been eliminated from the main floor-- Creating a master suite by taking a bedroom and turning it into a master closet and bathroom off the largest bedroom-- New tile front porch, landscaping and garage doors-- New paint, light fixtures, etc. throughoutThe age of the house caused a couple budget issues during renovation, but our biggest roadblock to an efficient renovation was from the GC's end.

There is a separate bedroom with closet and a bathroom, but in order to access the egress, it would require going through a doorway. 

If garage is converted to a sleeping room then there must not be any gas fired water heater in the closet of that converted room5.