Sorry to hear of your troubles, this is a good reminder that the house has to "qualify" for the loan too.
It really depends on the appraiser you get. I had one with a non-permitted garage fly through with no issues on FHA and then another that they stopped it dead in the tracks. Both were done with "good workmanship". Both about the same age/time period but one appraiser called it out on the appraisal and the other did not (and did not include that room in the square footage.)
CJ : )
The reason for our transaction was adhering to the City of Anaheim's zoning and building code. I called the building and planning department and the issue was related to exponential population growth in the neighborhood with insufficient support of infrastructure for water & sewer. So, the City required the removal of the addition "until" the City has the funds allocated to improve the infrastructure.
So my suggestion for you is to contact the local city and planning department, provide the property address, describe the situation and they will tell you what you can and can not do. Based on the City's comments, then you decide whether the subject property is worh pursuing.
You can NOT get around local city zoning and building codes. So it doesn't matter what the Seller, the Appraiser, or FHA would agree, disagree, pass, or not pass.
I hope the information helps.
Your buyer's agent should be able to bring their negotiation skills to the table on this one. If you still want to pursue this home, then submit the offer under an FHA 203K loan. As you can't pay for any modifications prior to owning the home, the seller won't pay for them, and FHA will not fund the loan without the modifications, it would normally appear that you're between a rock and a hard place. The 203K loan allows the appraisal to be completed assuming all repairs are made and the cost of those repairs are in your mortgage. That's the only way I know how to get around this.
As for the reason why, again? Beats me, as when I read their guidelines, I don't see it listed as any hard fast rule....unless the value cannot be justified with the converted garage.