The house I'm buying is only worth $40k and the rebuild cost shouldn't be over $100k.

I think the best option would be to tear down and rebuild.

The city will require you to rebuild to the current code, but your insurance company will only replace what you lost, which was a noncompliant doorway. 

Further, if you had to leverage it in order to access your cash, you would be upside down, so from that point of view I would try to put every penny you get from the property in rent into a cash fund so that you rebuild (assuming you need to rebuild) your reserves. 

I've been using a general rule of thumb that considers the overall property appraised value less the land in the event I would have a total catastrophe and have to rebuild the entire home. 

That means that the land is 33% of the total lot value, so in my example, you allocate $50,000 to Land Value and $100,000 to Building Value.Fees to demo structures are added to the land basis.Fees to rebuild or fix structures are added to the building basis.Penalties and fees are a non-deductible expense (you never get a deduction for breaking the law), but any interest added to the account can be added to basis.Legal fees - this is a tough one.  

Cap rates have compressed to where market value is close to re-build cost.

I don't see bringing to code as a realistic possibility because of the condition.My game plan would be to demolish and rebuild, the lot already has city water and sewer with no outstanding bills owed, the taxes are also current.

They're selling a portion of the house to the insurance company and don't want to suffer thru rebuilding.

That way if I did have a total loss I may have a leg to stand on in court when the insured amount did not cover the re-build cost.