If you have it mounted inside then it will have to be vented...the set up for venting is extra. The only concern some have about placing it outside is if you are in a very cold climate. We are in central AL and we do get weather in the 20's on occasion..more than we used to :( It hasn't been a problem. We have a 4000 sq foot home and the 6.5 has been plenty for us even when we have company. Our water heater was in a closet within a closet...and it was gas..believe me I know what you mean when you say it gives you the willies ! I couldn't wait to get it out if there. I was able to reconfigure the entry way to our master bedroom and make it a double door...I love it !! Once you have the tankless you never again have to worry about the storage of hot water like with the regular water heater. Also new water heaters don't last at all like the old ones. Ask any plumber or even the sales people. Old ones used to last for decades but those days are over. You will love your tankless. c

Mechanical Codes require flues or chimney to be resized if appliances are removed and some appliances are left 'orphaned'. It is likely that your home inspector uncovered a Code violation and unsafe condition because of this 'orphaned' water heater. The simplest means to correct the problem is usually to replace the water heater with a new one and have that new water heater direct vented or power vented to the exterior. This should be done at the current owner's expense. Contact your local mechanical code inspector for details.

These are the rules in my Ontario: 8.14.2 Except for a special venting system with positive vent pressure, a vent shall extend not less than 2 ft (600 mm) above the highest point where it passes through a flat roof of a building and not less than 2 ft (600 mm) higher than any portion of a building within a horizontal distance of 10 ft (3 m). 8.14.4 A chimney shall extend not less than 3 ft (900 mm) above the highest point where it passes through the roof of a building and not less than 2 ft (600 mm) higher than any portion of a building within a horizontal distance of 10 ft (3 m). 8.14.5 Except for a special venting system with positive vent pressure, a vent passing through a pitched roof shall extend above the highest point where it passes through a roof surface in accordance with Figure 8.1 and shall extend not less than 2 ft (600 mm) above any other obstruction within a horizontal distance of 10 ft (3 m). 8.14.6 A vent or chimney shall extend not less than 5 ft (1.5 m) in height above either the highest connected appliance draft-hood outlet or flue collar except as provided in Clause 8.24.1. 8.14.12 A vent from an appliance shall not extend through an exterior wall and terminate adjacent to the exterior wall unless (a) the appliance is a direct-vent appliance; (b) the appliance is intended for connection to a special venting system; (c) the appliance and its complete vent assembly are specifically certified to be installed in this manner; (d) the venting system is equipped with a certified power venter that complies with Clause 8.29.2; or (e) the venting system is equipped with a certified power venter that complies with Clause 8.24.2. Please get a qualified installer to find a remedy for you.

Generally gas heater vent pipes are zero clearance since they are double walled (one pipe inside another). However, the only way to be absolutely certain your installation is proper for your area is to check your local Building code. You also need to make sure that you install the proper connection at the heater outlet as there is typically a requirement that air be allowed to enter the exhaust flow.