Zoning laws are for public knowledge, so you'll be able to ask the city if the property is zoned for a guest house or not. Based on that one picture, the shed does not look like it's in the best condition. Is the shed being torn down and rebuilt as a larger guest house?

That's great! Once you have a plat, you'll know the extent to which you can build. When you know how much space you have, it will be time to develop a floor plan. Do you have a builder that will construct the guest home for you? This seems a little overly ambitious as a DIY project.