The 80% rule refers to the fact that most insurance companies will not fully cover the cost of damage to a house due to the occurrence of an insured event (e.g. fire or flood), unless the homeowner has purchased insurance coverage that is equal to at least 80% of the house's total replacement value. In the event that a homeowner has purchased an amount of coverage that is less than the minimum 80%, the insurance company will only reimburse the homeowner a proportionate amount of the required minimum coverage that should have been purchased.
For example, let's say that James owns a house with a replacement cost of $500,000 and his insurance coverage totals $395,000, but an unanticipated flood does $250,000 worth of damage to his house. At first glance, you might assume that since the amount of coverage is greater than the cost of the damage ($395,000 vs. $250,000), the insurance company should reimburse the entire amount to James. However, because of the 80% rule, this is not necessarily the case.
According to the 80% rule, the minimum coverage that James should have purchased for his home is $400,000 ($500,000 x 80%). If that threshold had been met, any and all partial damages to James's home would be paid by the insurance company. But since James did not buy the minimum amount of coverage, the insurance company would only pay for the proportion of the minimum coverage represented
by the actual amount of insurance purchased - that is $395,000/$400,000, which amounts to 98.75% of the damages. Therefore, the insurance company would pay out $246,875 worth of the damages and, unfortunately, James would have to pay the remaining $3,125 himself.
Since capital improvements increase the replacement value of a house, it's possible that coverage that would have been enough to meet the 80% rule before the improvements will no longer be sufficient after.
For example, let's say that James realizes that he did not purchase enough insurance to cover the 80% rule, so he goes and purchases coverage that covers $400,000. One year passes and James decides to build a new addition to his house, which raises the replacement value to $510,000. While the $400,000 would have been sufficient to cover the $500,000 house ($400,000/$500,000 = 80%), the capital improvement has driven up the replacement value of the house, and this coverage is no longer enough ($400,000/$510,000 = 78.43%). In this case, the insurance company will once again not fully compensate the cost of any partial damages.
Inflation can also cause the replacement value of a house to creep up in value, so it would be wise for homeowners to periodically review their insurance policies and home replacement values to see if they have adequate coverage to fully cover partial damages.
To learn more, see A Tax Primer For Homeowners and Smart Real Estate Transactions .