J Van Horn,
1) Yes, we were reviewing this option yesterday afternoon from the FAQ. The building isn't factored into the appraisal, however, at this point I also doubt they took into any adverse affect that having half of the neighbor's outhouse on the property might have.
2) That's a good point, he probably can't insure it even if he wanted to (he doesn't, he jokingly indicated he would bulldoze the half of a building before buying flood insurance on it).
Everything is on hold though until this is sorted out. Still waiting to hear back from the title co. Our borrow has a good relationship with the neighbor so the structure will get sorted out one way or another before we proceed. I appreciate the input!