If you can't convert the whole place to a LTR, then let it go and find another place.Having said that, is the place split into 2 legal residences?

Increase supply (or at least encourage development), and the prices will eventually come down (as we've seen in other large cities like Austin where the demand boom was followed by a supply boom - and now both sale prices and rents have gone down). 

We were going to buy a house next year so I told her that we would buy a 4 or five bedroom house or a house that we can convert to 4 or 5 bedrooms.

If you did not and it’s unsecured debt you could be out of luck on some or all of the money as depending on his situation unsecured creditors in a bk may receive pennies on the dollar depending on what he can afford and if converted to a ch 7 you would get wiped out.Even in 2nd position he could argue the property is underwater and wipe out your lien.

However, over the last 20 years there have been some favorable plms and rev rulings (particularly surrounding trusts) that owning a membership in an entity and converting that to tic still equated to the same level of ownership. 

Long term investors will eventually have a large loss claim so appreciate you sharing if you can.  

While I love the idea of eventually owning a paid-off primary residence, I’m debating whether it’s smarter to sell our current house and use the equity as a down payment on the new home or to keep it as a rental.

Also, expect deferred maintenance.Your #1 concern should be, can you fix the problems the seller has or will you eventually have to dump the property also?

I converted my short-term rental to a long-term this year.

She was facing charges but they eventually got dropped and Lee's people fixed everything, got it on the market and she got like $50,000.00 from the sale proceeds.