Disclaimer: I am not a professional plumber.If it's an electric water heater, this doesn't apply.If it's a gas water heater... do you have a sufficient supply of combustion air to the closet you made?

We also converted an attached shed into a laundry room/pantry that was accessible from inside the home.It was originally listed as a 2/1 but had a den with no closet, so they could not list it as a 3 bedroom.

Some already existing, some about to come out of the closet.

I could then build more closet space and, possibly, add a master bath. 

Tenants moving out showed me mold in the closets.

This is with custom cabinets, walkin closet custom shelving and the whole other things involved with gut renovation. 

We got it for about 80% of market value and knew it wasn't a fantastic deal after factoring the rehab but the numbers were still pretty good and the location is solid.The good:all replacement windowsamazing first floor layout with 10' ceilingslots of light and good viewsgreat location for nightlife, walking, bus linepossible hardwoods throughout first floor (waiting for painting to be done to remove 100 year old wall to wall carpet)The bad:only bathroom is on second flooreverything is from 1940small bedroomsspent roof (we knew this coming in)The ugly:super weird bedroom layout, one closet is in the bathroom!

I went up there, and sure enough there were inflatable beds in the rooms, portable refrigerator, barbecue grill, etc.My question is, what do you think is the best way to handle this?

Depending on the nature and extent of the damage you mentioned, new wood of the same sort is expensive to come by, so if repair wood could not be pulled out of closet areas then new flooring for the whole area begins to make more sense. 

Needs to be at least 10x10, one closet and one window to become a bedroom.