As an agent, I am working with a buyer who is showing interest in a particular home that is a legal two family, the basement is set up as an illegal third unit. Being that the property is located in New York, what are some risks/ consequences (and possible rewards) associated with buying such a property? 

@Ryan Cleary , happy to connect you to a re lawyer I work with.

It depends on the local laws, but I would base my numbers on a 2 unit + the cost of conversion if needed.

Duplex it with the 1st floor. It won't get as much yield/rent as a unit standalone, but you'll be able to maximize it as a larger unit and still monetize without any issues so long as you note in the lease. 

@Ryan Cleary how have you been?   I have run into this issue many times in NJ, my understanding is the laws are similar.  The safest approach would be utilizing the basement space legally.   @Alexander Szikla approach is best bet.   Some things to look for are bedroom regulations for basements in your area, what is required for it to be a legal bedroom.  I have successfully converted an illegal quad to a duplex and illegal 3plex to a duplex.   In both scenarios  I was able to match rent or get more in rent while having less tenants and legal apartments.    

@Ryan Cleary As mentioned above, I would definitely advise having the client speak to a RE attorney about this to see A) what kind of issues it can present and B) What constitutes a legal third unit and/or what measures can be taken to make it legal. I can speak from personal experience as I dealt with this on one of my own multi-family deals--it can present itself during closing when trying to get a CCO. If an actual inspection is done by the city, it's more than likely the illegal third unit will be discovered by the building inspector and would have to be remedied before getting the CCO, plus any fines that they may choose to issue retroactively.

@Ryan Cleary many cities turn a blind eye to unpermitted extra units, unless there is some type of fire egress issue. Make sure the space has egress windows in the bedrooms to escape in a fire. The risk could be severe if there isn't fire egress and you have a fire. Your insurance company could deny the claim and you could be sued for wrongful death by tenants relatives. People have even been criminally prosecuted for knowingly enabling a dangerous situation. That is extreme, but it happens. More importantly as a human being, who wants to live knowing their negligence lead to someone's death? We take tenant safety very seriously. Money is not worth a life.

Ryan,

Your clients need to review this with their insurance agent.  The agent needs to find out how the companies they represent will treat it.  I've seen most companies reject a policy in that situation.  But I have also seen companies accept it.  The ones that did acept it, made sure that the value being insured was the rebuilding cost to a 2 family not a 3.  In this case, they would not provide any coverage for the basement kitchen, bath, etc.

The other thing they will most likely insist on is that it is up to fire code and has two means of egress.  Even if they did not insist on it, I would strongly recommend that to my client as this could be a major area of Liability.