October to December Quarterly Newsletter 2019 Oahu
The Oahu real estate market finished the year off strong. The December median sales price for single-family homes was $820,000 (4.1% higher than December 2018) and for condos was $425,500 (6.8% higher than December 2018). Compared to December 2018, single-family home demand jumped 19.3% while demand for condos dropped 2.7%. The supply of available homes is still tight. There are currently 2.5 months of single-family homes inventory and 3.4 months of condo inventory (six months of inventory is considered a balanced market).
The University of Hawaii Economic Research Organization (UHERO) predicts that Hawaii’s economy will eek out a small gain despite falling real visitor spending and a declining population. Visitor arrivals are expected to grow again next year but per visitor spending is expected to drop due to global economic weakness. Payroll job growth dropped to zero last year due to outward migration and real personal income is expected to lag Honolulu’s inflation rate over the next three years. Hawaii’s labor force has dropped by about 25,000 individuals since 2017 and Hawaii lost 4,721 residents from July 2018 to July 2019. A recent study by the Department of Defense (DOD) has found that rental prices have fallen about 3% in the past few years on Oahu while calculating the military’s Basic Allowance for Housing. Zumper reported that median rents for a one-bedroom Honolulu rental have dropped 10% to $1,600 month and median rents for a two-bedroom Honolulu rental have dropped 4.5% to $2,100 per month.
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The Honolulu Star Advertiser reported on the unique ceremony for interring the ashes of Lauren Bruner, most likely the last USS Arizona survivor to join the rest of his shipmates in gun turret 44. Two Army divers wore vintage Mark 5 hardhats, lead boots, and dry suits that weighed about 200 pounds to deliver Bruner’s ashes to his final resting spot. More than 900 sailors remain entombed on the USS Arizona from when a huge explosion sank the battleship 78 years ago. The US Navy from 1916 to the early 1980’s used the Mark 5 Dive Rig. Bruner, who died at the age of 98 on September 10th, was likely the last survivor to join 43 other Arizona survivors who chose to be interred in gun turret 4. There are only three shipmates remaining alive of the original crew of 1,512 sailors and they have chosen to be buried in family plots. A ceremony was also held for the 58 sailors killed on the USS Utah that was torpedoed, capsized, and sank within 12 minutes. 54 sailors were never recovered and the USS Utah serves as a burial for those that died. 96-year old Burke Waldron attended the ceremony honoring those that had fallen and 100-year old Warren Upton listened to the names of his fallen shipmates read allowed. They are two of the remaining three survivors of the USS Utah still alive. The two ceremonies were part of the events commemorating the bombing of Pearl Harbor on December 7th.
Two protests dominated the headlines in the last quarter of 2019 and the outcomes were dramatically different. The protests over the Thirty Meter Telescope (TMT) started in July and the protestors have successfully blocked construction equipment from accessing Mauna Kea’s summit. The protests over the Na Pua Makani wind farm project in Kahuku resulted in the arrest of approximately 200 protestors while the contractor delivered the wind turbine parts over a span of five weeks.
237 Honolulu Police Department (HPD) officers assisted the developer in providing access to the site for the first of several deliveries on October 18th. Four oversized trucks headed to Kahuku at 1:15 am on Friday morning with police escorts and had to wait for clearance of a utility pole that was cut down by a chain saw along the route at about 3:00 am. Approximately 1,000 people lost power and the repairs delayed thousands of residents from getting to school and work. Kamehameha Highway was reopened about 7:30 am, police arrested protestors blocking the delivery site around 8:15 am, and the delivery was completed about 10:15 am. The following Monday, vandals damaged one of the windmill foundations while additional protestors were arrested. The number of arrested protestors has dropped over the last few days since bail increases for each individual with subsequent arrests. Roughly 100 protestors attended a Public Utilities Commission (PUC) hearing on November 22nd and silently observed three attorneys challenge to PUCs decision to approve the Na Pua Makani wind farm project in Kahuku. Some of the protestors wore yellow pieces of duct tape across their mouths. The protest has entered a new phase since the project’s contractor finished delivery of the wind turbine parts.
Tension concerning the Thirty Meter Telescope (TMT) protests boiled over on the Big Island as the Hawaii County Council rejected the agreement that mayor Harry Kim reached with the state concerning reimbursement for police overtime during the protests in a 9-0 vote. The council members sent the mayor a message that he must consult with them before entering into an agreement with the state. The council members were opposed to the deal because it required county police to respond to Mauna Kea protests for five more years. The state and county spent about $15 million during the 22 weeks of non-violent protests. Hawaii County spent about $4.7 million in police overtime alone. The TMT protestors cleared from Mauna Kea Access Road on December 28th, two days after Governor David Ige’s deadline to clear the road or face arrest. The protestors agreed to move once they received word that TMT would not proceed with construction over the next two months. TMT opponents are still determined that the telescope will never be built on the summit of Mauna Kea. To that end, the protestors plan on shifting the focus of the protest to people on the mainland. TMT supporters gathered outside the Hawaii Convention Center on January 5th to show support for the project during the 235th meeting of the American Astronomical Society consisting of more than 3,400 astronomers, professors, and students.
Some people have criticized Mayor Harry Kim’s and Governor David Ige’s hesitation to use law enforcement to provide access to TMT construction crews in light of Mayor Kirk Caldwell’s actions to provide access to the Na Pua Makani wind farm project. Meanwhile, The Canary Islands Astro-physics Institute Director has announced that the building permit for the Thirty Meter Telescope (TMT) was granted on the La Palma Island and no additional permitting is needed. Both the summits of Mauna Kea and La Palma are considered among the best sites for deep-space observation and astronomers hope that TMT will enable them to examine the time immediately following the Big Bang. The state of Hawaii might squander a great opportunity if Governor David Ige fails to break the impasse with the protestors on Mauna Kea.
The State of Hawaii sent out a notice regarding mandatory electronic filing of taxes in 2020 including the General Excise Tax. Department of Taxation Announcement No. 2019-16 states that periodic general excise tax returns (form G-45) for months beginning on or after July, 1 2020 must be filed electronically and that annual returns (form G-49) for taxable years beginning on or after January 1, 2020 must be filed electronically. Electronic filing is available on Hawaii Tax Online (https://hitax.hawaii.gov).
Airbnb has come to an agreement with the state of Hawaii to turn over records of 1,000 hosts who made the most revenue from 2016 through 2018. Airbnb will give the hosts two weeks’ notice prior to turning over the information. Airbnb will also provide anonymous data on hosts making more than $2,000 in annual revenue from 2016 and 2018. The state Department of Taxation may then request individual information for these hosts. If a host makes a legal challenge, then Airbnb will not turn over the data until the legal case is resolved. A judge approved the agreement. The state must receive permission to serve the subpoena since the investigation is targeting a group of taxpayers and not a specific individual. Airbnb hosts making less than $2,000 per year annually will receive a letter spelling out the requirements for the state’s General Excise Tax and Transient Accommodations Tax.
The Honolulu City Council passed and Mayor Kirk Caldwell signed a bill that creates a new tax category for Oahu residential properties that run bed and breakfast businesses (B&Bs) and places transient vacation units (TVUs), residents that are entirely rented out on a short-term basis, into the hotel-resort category. The tax rates apply to new vacation rental properties licensed under Ordinance 19-18. Bill 55 keeps the tax rates the same for those owners that have been operating Bed & Breakfasts and Transient Vacation Units under existing non-conforming use certificates. Rates for the new category will likely be raised between the current residential rate of $3.50 per $1,000 of assessed value and the hotel rate of $13.90 per $1,000 of assessed value. The city council will set tax rates in June 2020 for the following fiscal year. The city council wanted the new category in place in preparation of the roughly 1,700 new permits for hosted bed-and-breakfast operations that the Department of Planning and Permitting (DPP) beginning October 2020.
Owners of Waikiki Banyan received a temporary stay preventing the city from enforcing the new short-term rental law. The city and Waikiki Banyan owners are working on a settlement since the building has been run as a hotel from its inception in 1979. The stay will remain in place until the parties reach an agreement or the Waikiki Banyan has exhausted all administrative remedies including a review by the courts. Many owners and even some supporters of Ordinance 19-18 have objected to the broad scope that DPP has applied the law in Waikiki and Turtle Bay where most view the locations as hotel-resort neighborhoods.
Ex-Deputy Prosecutor Katherine Kealoha pleaded guilty to three felony charges that included one charge of aggravated identity theft, one count of bank fraud, and failure to report a felony to federal authorities. Katherine admitted to withholding key information from Honolulu detectives that were investigating a drug-dealing ring that involved her brother, Dr. Rudolph Puana. Former Honolulu Police Department (HPD) Police Chief Louis Kealoha pleaded guilty to one count of bank fraud. Sentencing for the two high profile city officials has not been scheduled. The Kealohas are required to pay restitution of more than $450,000 to victims of their crimes as part of the plea deal. Federal prosecutors have filed charges against Dr. Puana and the Kealohas have agreed to cooperate with investigations involving Dr. Puana, Prosecutor Keith Kaneshiro, and the city of Honolulu’s top civil attorney, Donna Leong. City and County of Honolulu taxpayers ended up footing the bill for the Kealoha’s defense totaling $700,000.
Hawaiian Electric Company’s electrical generating station at Schofield Barracks received an achievement award from the Association of Edison Illuminating Companies for advancing operations in the electric energy industry. The 50-megawatt station was a joint U.S. Army and HECO project that came on line last year in an effort to add resiliency to on-base renewable energy generation while feeding the island grid. The generators are capable of using biofuel and it is the only power plant on Oahu located at the center of the island making it less vulnerable to ocean related natural disasters. The quick starting generators increase HECO’s ability to add additional solar and wind power and are expected to reduce oil use by 26,000 barrels annually.
The #18 University of Hawaii (UH) Rainbow Wahine’s volleyball season came to an end in a losing effort to #5 Nebraska Corn Huskers in straight sets during the third round of the NCAA tournament. UH was leading in the first set 17-10 but could not hold off Nebraska who came back to win 29-27, 25-22, 25-19. The Rainbow Wahine finished a fabulous season at 26-4, won their first Big West title in coach Robyn Ah Mow’s third season, and returned to the third round of the NCAA tournament for the first time since 2016. UH has high hopes for the future with five freshmen returning.
The UH Rainbow Warrior football season came to a thrilling conclusion with a last minute comeback victory over Brigham Young University in the Hawaii Bowl. Cole Hamilton threw a 24-yard touchdown pass with a little over one minute remaining to put UH on top, 38-34. The Rainbow Warriors finished the season 10-5.
Hawaii’s state bird, the nene, has been removed from the endangered species list. The nene currently number about 2,800 in the wild. The birds have gradually recovered when roughly thirty wild nene existed in the 1960’s. Over the following decades, more than 3,000 captive birds have been released at more than twenty sites including wildlife refuges, national and state parks, and private land throughout the state. Nene geese were first observed back on Oahu in January 2014. The nene is still a threatened species and scientists will continue to monitor their recovery.
Tim and Tracey recently returned from an action-packed three-day trip to New York City celebrating Ashley’s (their daughter) graduation from Duke University. Tim, Tracey, Ashley, Mark, and friend David visited the Empire State Building, the 9/11 Memorial, the Jewish Heritage Museum, went up to the crown of the Statue of Liberty, and saw the Rockettes, Wicked, and Hamilton. Tracey met a newsletter recipient that works in theatre during an open house this year who graciously arranged back-stage passes to Radio City Music Hall (the Rockettes) and Hamilton when she heard that we were on our way to her city. We were so grateful for the incredible experience. Below is the photo of the Kelley family inside the crown.
ODDS AND ENDS
Fresh Start to 2020: Stott Real Estate, Inc. and Stott Property Management, LLC can help you quantify what your property is worth in monetary terms and how much rent it can generate. However, you must answer how much joy owning a piece of the islands gives you. We suggest that you ask yourselves a couple of questions during the start of a new decade.
Does the thought of your property make you happy? We are well aware that not all absentee owners look to generate rental income because they want to stay in their second home when they periodically come to visit. Always having a place to call home when staying in paradise is worth the added expense of owning a second home. Second homeowners can tailor their property to fit their particular needs and establish routines filled with events and experiences that they like the most.
Does the monthly rental income make you happy? Does the market support your cash flow goals for the property or cover enough of the expenses of owning a second home to justify renting it out and dealing with the additional wear and tear from tenant use. Not all tenants may treat your furnishings as gently as you would like and may not always leave your rental property as clean as desired. However, if the rent is high enough, then you can replace items as they wear out and allow for professional cleaners to come in before your arrival or before the next set of guests.
If the answer to both of the questions is yes, then we don’t see any reason to make changes. If one of the question is no, then there are likely other factors to be considered before deciding if holding onto the property is the best course of action. For instance, we have had clients who absolutely love their home and are moving away for a period of time before returning. The clients tolerated some negative cash flow because they did not want to risk being unable to find a similar home when it was time to move back. Other clients have held on for the emotional ties that they or a loved one had for the property.
If the answer to both of the questions is no, then it is logical to consider selling a property that no longer fulfills the goals that you originally had or has become a source of stress. We will be happy to help provide you with information and different solutions if the status quo is not working for you. Sellers can defer capital gains taxes on an investment property by conducting a 1031 Exchange. However, some investors may just want to pay the taxes associated with capital gains and depreciation recapture and use the proceeds for other investments that provide a better return, pay off debt like a mortgage on the home they live in, and/or provide a cash cushion for future expenses.
Subrogation: It is very important to read the condo association bylaws carefully before proceeding with a condo purchase. Water leaks and water remediation can be very expensive and associations often handle cases very differently when a condo’s plumbing leaks into one or more other condos.
Subrogation is the insurance term where a company will pay one of its insured parties for damages then make its own claim against the owner whose property caused the loss. When an association allows subrogation, the owner whose unit caused damage to other units is responsible for repairing the water damage in the affected units. Some associations require policies to contain “waivers of subrogation” meaning that the insurance company may not make a claim against the owner of the property that caused the loss. In this case, each owner is responsible for repairing his or her individual unit.
It’s critical to understand how your association handles leaks to determine potential liability if you have a water leak in your condo, quickly repairing the water damage, and efficiently handling claims.
1031 EXCHANGE OVERVIEW
Purpose: The purpose of this article is to provide an overview of a 1031 exchange. The article is rather basic and not intended to be a guide to an actual exchange, as it omits rules and that could significantly impact upon a 1031 exchange. We have prepared a more detailed paper in a question & answer format using layman terminology that explains the process in considerably more detail. To obtain a copy, check the applicable block on the enclosed postcard and return it or e-mail us at [email protected]. If you provide us your e-mail address, we’ll e-mail or mail you a copy of both the 1031 paper and the HARPTA paper that discusses the Hawaii law that enables the state to collect estimated capital gains taxes from owners that might not file a Hawaii tax return in the year of the sale.
Note: We have participated in a large number of 1031 exchanges and usually have several such transactions in escrow at any given time. However, we are not licensed to provide either legal or tax advice. Licensed professionals such as attorneys or CPA’s should be consulted for such advice. This comment applies to the entire newsletter.
Note: This paper will use the terms “old property” for the property being sold and “new property” for the property being purchased. A property may consist of more than one piece of real estate.
Background: Section 1031 of the internal revenue code (IRC) provides for the deferment of long-term capital gains taxes on the sale of investment real estate when it is exchanged for other investment real estate of equal or greater value than the real estate being sold. A common misconception is you will have to find someone to trade properties with you. Most 1031 exchanges involve two entirely separate transactions. In one transaction, you sell your old property and in the other, you purchase your new property. There is normally no reason for the buyer of your old property and the seller of the new property to have any contact with each other. Often, the properties are located in two different states; e.g., most of our exchanges involve property in Hawaii being exchanged for property on the mainland.
Qualified Intermediary (QI): The IRS mandates that you use a completely independent third party to supervise the exchange. Because this third party must be completely independent, it cannot be your real estate agent, accountant or attorney. The independent third party is usually referred to either as an intermediary or as qualified intermediary (QI); however, in some areas of the country the third party may be called either a facilitator or an accommodator. This paper will use the term “QI.” The QI can be located anywhere in the country; they do not need to be located near you or near either of the properties involved in the exchange.
The following steps have been changed; however, they help explain the role of the QI. The QI takes title to the old property for a brief instant in the process of having it sold from you to the buyer; i.e., title passes from you through the QI to the buyer. Similarly, the QI takes title to the new property for a brief instant in the process of having it sold from the seller to you. Therefore, the QI has owned both the old and the new properties and can exchange one for the other. Today, the QI no longer has to hold title to both properties. In 1991, the real estate industry successfully lobbied Congress to have the law changed, as escrow companies were charging double escrow fees; i.e. Seller to QI and then QI to you. Today, in lieu of taking title to both properties, the QI is tasked to provide instructions so that both transactions are closed in a manner that conforms to section 1031 of the IRC.
Properties & Timing: Both the old property and the new property must be investment real estate; in most cases they are rental properties. The two properties do not need to be the similar; e.g., you could exchange a house in Hawaii for two or more Mainland condos and vice versa. Almost any type of real estate qualifies such as a house, condo, store, office or even vacant land. However, your personal residence or a second home does not qualify. Moreover, you could rent the new property first so that it qualifies as investment property and then occupy it yourself. Many of our clients do this; i.e., they use equity in their Oahu property to assist them in purchasing a future Mainland residence. The new property must be rented for at least a year prior to being occupied in order for it to qualify as investment real estate.
With some very few exceptions, all of the exchanges made by our clients have been deferred exchanges where the old property is sold prior to purchasing the new property. It is possible to do this in reverse order and purchase the new property first; i.e., prior to selling the old property. This is called a reverse exchange and is far more complicated and expensive than a deferred exchange. This article is based upon deferred exchanges. Over half of our deferred exchanges involved absentee owners conducting their first 1031 exchange.
When the old property closes, the proceeds from the sale go to the QI who banks the funds until you’re ready to purchase the new property. To defer all your capital gains taxes, you must buy new property that is equal to or higher in value than the old property. You must also reinvest all the cash proceeds from the sale into the purchase of the new property. The QI maintains the funds from the sale of the disposable property and then makes those funds available in order to enable the purchase of the new property. You cannot have access to any of the proceeds from the sale of the old property or those funds will be taxed.
There are two key time frames both measured from the closing date of the old property. Failure to meet either of these two time frames negates the tax-deferred 1031 exchange.
Within 45 days, the new property must be identified in writing to the QI. You can make changes to your identification any time within the 45-day-period; however, on the 46th day, you are locked-in to whatever has been identified as new property.
Within 180 days, the new property must close. You can identify more than one property; so if your preferred new property falls out of escrow, you could shift to a replacement new property that was identified during the 45-day-period; however, it would still have to be closed within the 180-day-period. Most exchangers identify more than one new property.
Deferring Taxes: A 1031 exchange enables an owner to be able to defer both the federal and state capital gains taxes that they have on the sale of their old property and roll those taxes over into the new property. Note that the taxes are deferred, not excluded. The current federal capital gains tax rate for most exchangers is 15% on all component of gain except depreciation recapture, which is taxed at 25%. The Hawaii capital gains tax rate is 7.25% on all components of gain including depreciation recapture. State taxes are a deduction for federal taxes; therefore, the combined tax rate is about 21% rather than 22.25% (15% + 7.25%).
Recent rules: Three relatively recent rules apply to principal residences. The tax relief act of 1997 enabled a homeowner to sell their principal residence and exclude up to $500,000 of gain (married) or up to $250,000 (single) providing they had occupied the home for an aggregate 24 out of the prior 60 months. So an owner only needed to own the property for three years, one year as a rental to qualify for the exchange and then two years as a principal residence to qualify for the tax relief act of 1997. In October 2004, there was a change to the 1997 law. An owner who acquired their principal residence by way of a 1031 exchange must now own the property for at least five years before they sell it in order to be eligible for the exclusion. The owner still needs to rent it for one or more years so it qualifies for the exchange and then have it be their principal residence for at least two years. The exchanger also has to pay depreciation recapture on depreciation claimed (after May 6, 1997) while the property was a rental; i.e., depreciation recapture while the property was a rental will not be excluded.
The Housing and Economic Act of 2008 reduces the capital gains that can be excluded when a homeowner sells a principal residence that they held as an investment property for a period of time as the amount of the tax exclusion will be adjusted by the non-resident use of the property. This law became effective 1/1/09. The amount of time of non-resident use after 1/1/09 is the numerator or top of a fraction with the bottom or denominator of the fraction being the total time since property acquisition. That fraction times total gain (exclusive of depreciation recapture after May 6, 1997) is the gain that will be taxed to the homeowner.
Example: Single Mary bought her Oahu home on 1/1/98 for $200,000 and rents it for 13 years until 1/1/11 when she occupies it as her principal residence. Seven years later, on 1/1/18, Mary sells the property for $500,000 and has $300,000 of gain.
The non-residence use of the property by Mary prior to 1/1/09 does not apply to the new law. Therefore, Mary has only two years of non-residence use (1/1/09 to 1/1/11) when she then occupies it as her principal residence. Five years later on 1/1/18 Mary will have owned it for a total of 20 years. Therefore, the fraction for non-resident use is 2/20. Or, the taxable gain is $300,000 x 1/10 or $30,000. The remaining $270,000 exceeds the $250,000 limit for single Mary, so Mary ends up with $50,000 taxable ($30,000 + $20,000) and $250,000 that is excluded. Mary would also owe depreciation recapture after May 6, 1997 that is taxed at 25%.
In our example, we used a long period of ownership before the eligibility date. If the property were acquired after the 1/1/09 eligibility date, the fraction will be much larger. For example, assume the property is acquired on 1/1/09, rented for three years and then occupied for two years, the non-resident use would be 3/7 or 43%. However, if it is rented for only one year and then occupied for six years, the non-resident use would only be 1/7 or 14%. Every day it is a rental property after 1/1/09 increases the capital gains taxes to the owner.
Granted, the new law has no impact if the owner never sells the property; however, few homes remain suitable for the same family over any extended period of time. Over time, most families desire a different location and/or a larger/smaller/more prestigious or a completely different type or style of home particularly after they retire or become empty nesters.
Reasons to Exchange: Most exchangers use 1031 exchanges to defer capital gains taxes. Many have long-range plans to eventually exclude their deferred taxes by converting a rental property into a primary residence even with ownership now a required five years. With proper planning, this is still a very viable investment tool, particularly for property bought prior to January 1, 2009.
Some final thoughts: A 1031 exchange is not the right investment tool for everyone. Over the years, we have assisted many owners in making a decision not to conduct an exchange. Often, all that was required was for us to estimate the owner’s capital gains taxes. Contact us toll-free (1-800-922-6811), locally (808-254-1515) or via e-mail ([email protected]). Since recent tax law changes have made estimating capital gains taxes exceeding complex, we recommend speaking with a Certified Public Accountant (CPA) or tax attorney prior to deciding on a course of action. Due to the value of real estate on Oahu, you will likely be pushed into the higher tax brackets if you have owned the investment property for a significant period of time and the resulting tax bill could be costly if you don’t conduct a 1031 exchange.