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Block of Flats - Unrecoverable VAT

It is vitally important that the correct sum insured is selected for rebuilding purposes and, for this reason, we always recommend that a professional valuation be sought periodically with the sum insured then being index linked on an on-going basis.

Most valuations are prepared on the basis that they exclude VAT in their calculations. In almost all cases, in respect of blocks of flats, the policyholder is not going to be VAT registered and so unrecoverable VAT is something that needs to be incorporated into the building sum insured. Unfortunately, this is something which is often overlooked or misunderstood, resulting in building sums insured being incorrectly stated.

To understand the principle that applies here it is important to understand that the sum insured for a buildings policy needs to be on the basis of reinstatement. Reinstatement works on the assumption that an insurer will pay for the replacement and repair of a property up to the point whereby it is more cost effective to demolish it and rebuild as new. Typically, if a property is more than half to two thirds damaged, it is usually quicker and more cost effective to rebuild than to repair.

Another factor that affects this is the VAT exemption which is granted for new building projects. With this is mind, the reality is that a badly damaged property will be demolished, the site cleared and the property built again as new with the cost of professional fees needing to be paid. VAT is liable on the costs incurred for the demolition, clearing the site and professional fees.

If the valuation report itemises these costs then VAT can be applied at the current rate to these items and added to the sum insured. In some cases, however, an itemisation is not provided and it is typical that, in a reinstatement sum insured, approximately 25% of this would relate to demolition, site clearance and professional fees. For this reason, an estimate of unrecoverable VAT on a declared value that does not include any provision for VAT would be 25% of the current tax rate applied to the whole sum insured, i.e. at the current rate of 20% x 25% you would need to make an allowance of 5%.

There are some exceptions to this general rule such as swimming pools, commercial areas and certain communal facilities. If the block contains any of these then it may be necessary to add VAT to these elements as well.

The two common mistakes are a) not to make any allowance for recoverable VAT; or b) apply VAT at the current rate to the whole sum insured. It is important, therefore, to understand if an insurer elects to repair that they will still be obliged to pay the policyholder unrecoverable VAT, providing that this cost is no more than the cost of reinstatement by demolishing and rebuilding the property. The presumption is always that the loss adjustor acting for the insurer will elect to demolish and rebuild if this is likely to be the more cost effective basis of reinstatement.

If a property is listed then there may be an obligation to rebuild either the façade or the entire property in a nature which is sympathetic to the original structure. Therefore, in the case of all listed property, specialist professional advice should be obtained in determining the buildings sum insured and the unrecoverable VAT element.

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