We've agreed to a contract on the property but have the Inspection still upcoming and can back out (or ask for a reduced sale price) if we find anything out of the ordinary that would greatly increase our rehab budget. 

He said " he would rather pay $2000 a month than sign a lease with such a crazy price hike "So I have a few options , give 60 days notice , move into the bigger house , now have my larger house, extra bathroom and garage for my hot rod and only increase my portion of mortgage $350 as I believe renting the 1/1 at $1300+ will be cake .Or supply 60 days notice and get new tenant at anywhere from 1850 -2150 a month and stay another year in our small 1/1 . 

You don't want to make the mistake of a $6,000 renovation that only increases the rent $60 and will take ten years to recoup the cost.

@Isaac Hebron on your units, add more value, raise rents, increase the property value and you could be sitting on a gold mine!

Could I not just increase earnest money deposit from the next buyer buying from me?

The way I got started is I went out and found a deal that had high value-add(Large margin between acquisition and repair cost and ARV), the value in the deal made it easy to finance, I mentioned to everyone I knew what I was doing and let them know I have a deal I am trying to find a partner for and I found an investor rather easily because of the value in the deal, the deal attracts funding, get yourself a deal and  you will find an investor.

The interior and landscaping are dated and could be updated to increase the home's value to the neighborhood median (close to $600k).Here are my ideas:1) move him into an apartment/condo2) buy the house as a purchase option3) renovate the home4) Sell the home5) buy a multifamily property in partnership with the father in law with the all the equity generated from selling his house.

I need to find a funnel for deals so I can increase my chances of finding that first deal. 

Although assuming some increase is a good idea,  I would be shocked if the taxes increased from 1020 to 2040. 

Price run ups continued through the summer but those increases drove demand away towards the end of June.