You can replace a structure but you could likely not do a complete demo if you want to retain the garage and it is non-conforming (doesn't meet current setbacks and such).

Not related to your question, but have you looked at alternative strategies such as rent by the room or turning a SFH into a non-conforming duplex? 

Your investment team will find properties that conform to the property profile and provide the information you need to make an informed decision, which includes:Candidate propertiesRentTime to rentROI/Cash flowRenovation items - The items that must be changed in order to attract the target tenant pool.Estimated renovation costNote that an MLS data sheet contains none of the above information.

Do you know of a lawyer who could help create a set of loan docs conforming to the laws in the state?.

@Raju Balakrishnan I think you'd be surprised how close we could get DSCR-based 30 year fixed rental financing to conforming jumbo rates right now. 

This route just doesn't allow you to split the utilities, and you have to conform to occupancy limits for the whole house, instead of the units individually.

One, it would be a non-conforming duplex because we wouldn't be living in it, risking municipal action against us.

It is usually far less expensive to do the rehab.....in my experience...you can even do a 'to the studs' remodel for less than new buildSometimes it is advantageous to keep a portion of the old house to conform with setbacks....don't know if this applies to you?

You can't have it both ways, and if you bring attention to the situation you'll probably just cause yourself problems.If I were you, and I intended to keep the 2 illegal units, I would probably provide the 7 leases early on in the refi process to establish "7 rental units" in the mortgage person's mind, and then just hope & pray that you don't get asked for a zoning certificate as part of the process.One other thing I'd say is that, again I don't recommend illegal units, but if you insist on keeping them (as many people do), I strongly recommend you comply with the fire code applicable to the number of rented units in the building.You mentioned two buildings, with a total of 7 units, and you said the building department had them as 3 & 2, which makes me think you have them rented as 4 & 3.If that's the case I would strongly recommend, if I were in your position, absolutely making sure that those buildings conform with the fire code for a 4-unit and 3-unit, respectively.

I am looking to possibly rebuild the second home on the lot but don't want that to impede my non-conforming use of the property.