Assess Your Basement's Condition
Take a good, hard look at your basement. Look for water, dampness, mold and mildew, and rot, and note any musty smells. These will need to be dealt with in order to make a pleasant and healthy living space.
Check the ceiling heights in all parts of the basement, particularly at the bottom of the basement stairs, which is often a very low point, particularly in older houses. Check with your local building code, as some require a certain ceiling height for approved living spaces.
Note the presence of all plumbing and electrical fixtures, and research how much addition, modification and upgrading these would require to make a livable space. Check the size and condition of your fuse box or breaker panel if it is in the basement.
Add a Kitchen and Bathroom
Plumb in a kitchen sink and install it into a kitchen cabinet with a counter. Install a stove and a refrigerator. Be sure that the electrical circuits to the basement are sufficient to run these appliances. An electric stove will require a 240v circuit.
Plumb in a toilet, a shower and a bathroom sink. If there is not a properly placed drain for these, you may need to build up the floor and run the drain to another location.
Build walls around the bathroom and, if there is space, around the kitchen in order to make the space seem more like a home.
Finish the Walls, Floors and Ceilings
Insulate the walls with rigid foam, and cover them with drywall. Paint the drywall a light color to brighten up the space and make it seem larger.
Drywall the ceiling if it is covered with pipes and wires. Alternatively, install a dropped ceiling, or leave the beams exposed to add character.
Finish the floor with tile or linoleum. Avoid wall-to-wall carpet and other absorbent textiles, as these will increase the chances of dampness and musty smells.