Quarterly Newsletter October - December 2020
P R I N T | R E P L I C A Median prices for both single-family homes and condos are hovering new records as limited supply continues to be absorbed by strong demand. The December median price for single-family homes was $870,000 (6.1% higher than December 2019) and for condos was $455,000 (6.9% higher than December 2019). 35.9% more single-family homes and 20.1% more condos were sold in December 2020 compared to December 2019 and pending sales for single-family homes climbed 45.4% and for condos climbed 29.5%. There is only 1.4 months of single-family homes available and 3.3 months of condos. It appears that the extremely limited number of available single-family homes and buyers increased confidence with social distancing practices has led to a resurgence in condo sales.
Only 22.1% of available hotel rooms were occupied in November, far below the 55% to 60% occupancy rate that most Hawaii hotels need to break even. Constant changes to Hawaii Safe Travels program have caused some would be travelers to postpone their plans and different rules on different islands create more headaches because many visitors prefer to visit more than one island during their vacation. Hawaii’s economic recovery is not expected to really start until the second half of 2021 when the new vaccines are widely available to the public. The University of Hawaii Economic Research Organization (UHERO) predicts 5.9 million visitor arrivals in 2021 in its optimistic scenario and just 2.8 million visitors in its pessimistic scenario. Only 1,000 out of the 8,000 unionized hotel workers are currently working with an estimated 75% of the hotels currently open. HTA estimates that occupancy rates will be about 46% at the end of the next year, lower than the 50% to 60% occupancy rates needed to break even. Vacation rental owners may want to adjust their forecasts lower based on the latest projections and determine if they can absorb the negative cash flow for another year. Much of Hawaii’s recovery depends on how rapidly the vaccine suppresses the nationwide infection rate.
A Mixed Plate of Talk Story
Pele woke from her two-year slumber on Sunday, December 20th, as three fissures started releasing lava from the side of Halemaumau crater and started creating a new lava lake after boiling off a basin of water at the bottom of the crater. United States Geological Survey (USGS) officials reported lava fountains as high as 165 feet and the crater lava lake has reached a depth of over 600 feet. The lava flow cannot be seen from the visitor lookouts, but people can watch spectacular red glowing clouds rise from the crater after the sun sets. USGS officials recommend visiting the site between 3:00 am and 4:00 am if you want to avoid the large crowds that have been gathering to witness the new eruption.
The state is shutting down Aloha Stadium at least three years before a replacement stadium will be built due to budgetary problems caused by the COVID-19 restrictions. Rust has been an ongoing problem for years and the aging facility is facing a $3.9 million dollar deficit for this fiscal year. A 2018 structural and safety report found severe corrosion in hundreds of places. The closure has left the University of Hawaii Warriors football team scrambling to find another home field on the islands to meet the capacity required by the Mountain West Conference. Oahu high schools will have to find other venues for weekend football games, concerts, and graduations. One event will continue during the new Aloha Stadium’s construction, the Swap Meet and Marketplace. The Swap Meet normally features more than 400 vendors and brought in about $4 million of the stadium’s $7 million budget. The state has budgeted $350 million for the new stadium project.
The Hawaii Homes Commission passed a proposal to build a new casino in Kapolei on land set aside for Native Hawaiians on a 5-4 vote. The proposal will not be sent to Governor David Ige for consideration. The vote proceeded without the consideration of the trust beneficiaries that are at least 50% Hawaiian. The controversial measure was passed because the Department of Hawaiian Home Lands (DHHL) has failed to build the necessary infrastructure for Native Hawaiians to build and move into homes for decades at current funding levels. The rushed vote also hopes to prevent the Las Vegas casino industry to mount a campaign to defeat the measure. DHHL estimates that it will cost at least $4.5 billion to install the infrastructure to serve the 28,000 Native Hawaiians on the wait list. DHHL has developed just 3,300 residential lots state-wide since 1995 and the wait list continues to grow. Governor David Ige threw ice water on the plan by stating that the social consequences would exceed the economic benefits. He also failed to mention any plan to accelerating development of DHHL lands to eliminate the wait list.
Several Oahu tourist attractions reopened recently after long shutdowns due to the Covid-19 pandemic. Hanauma Bay reopened to the public with a new daily limit of 720 people per day to see if a balance can be found between conservation and public access to one of Oahu’s ocean treasures. Tim and Tracey decided against visiting when they heard that wait times were up to two hours first thing in the morning. Dole Plantation, the most visited Hawaii attraction in 2019 with 1,975,980 guests, reopened on November 12th. The facility temporarily closed when the 14-day quarantine was put in place by Governor Ige. Its current hours are Thursday through Tuesday from 10:00 am to 4:00 pm and will be closed on Wednesday to allow for deep cleaning. The Battleship Missouri (Mighty Mo) Memorial opened on December 16th to join the other open Pearl Harbor attractions, the USS Arizona Memorial, Pearl Harbor Aviation Museum, and the USS Bowfin Submarine Museum and Park. Diamond Head State Monument reopened on December 17th. The park will be open on Thursday through Sunday from 6:00 am to 4:00 pm. Mask wearing and six-foot physical distancing are required throughout the state park.
Mayor Kirk Caldwell teamed up with the Honolulu Authority for Rapid Transportation (HART) Board Chairman and the City Council Budget Chairman to bypass HART CEO Andrew Robbins and submit a preliminary recovery plan to the Federal Transit Administration (FTA). The cost projections submitted estimate the rail project to cost $11.2 billion ($10.2 billion in construction costs and another $1 billion in financing costs), $1.1 billion higher than the estimate provided by HART one month earlier. The total cost of the project is now projected to be more than double the $5.3 billion dollar price tag sold to Honolulu residents by Caldwell and then Mayor Mufi Hanneman back in 2008 and will finish fourteen years later than the originally projected completion date. The HART did not renew CEO Anthony Robbins contract and named Lori Kahikina as interim CEO making her the seventh leader of the organization during its tumultuous 10-year existence. She most recently managed more than $5 billion in construction contracts to upgrade the City and County of Honolulu’s sewage collection and treatment facilities to comply with the Environmental Protection Agency’s (EPA) decrees tied to untreated sewage discharges to the ocean going back decades. HART recently received a one-year extension to December 31, 2021 as part of a U.S. appropriations bill giving HART more time to find additional funds to pay for the system to qualify for the remaining $250 million of federal funding.
Honolulu Mayor Rick Blangiardi was sworn in as Honolulu’s 15th mayor on Saturday, January 2nd, 2021 and five of the nine Honolulu City Council Members (Calvin Say, Esther Kiaaina, Andria Tupola, Radiant Cordero, and Augie Tulba) started their tenures for the first time. Honolulu residents hoped that the newcomers can steer the city away from its numerous scandals that have plagued the city for the past decade when it soundly rejected candidates with extensive state and local government experience. 45% of Blangiardi’s new cabinet have significant operational experience in the private sector and that may signal a more business friendly administration.
The Honolulu Police Department (HPD) suspended the use of a special COVID-19 enforcement team in November and has acknowledged that 59 officers have racked up at least 130 hours each in overtime over the past month in violation of department policies. A report by the Caldwell administration reported that $16 million of the $17 million in CARES funding that could be spent by Oahu for overtime went to the police. Meanwhile, the prosecutor’s office has declined to prosecute, or a judge has dismissed more than 58,000 of the 60,000 citations issued by the police who were enforcing Mayor Kirk Caldwell’s arbitrary COVID-19 restrictions during the pandemic. It appears that the special COVID-19 enforcement team has turned into a very expensive public harassment campaign against the very same people that will be paying the tab. One notable exception is that the city prosecutors are continuing to prosecute U.S. Surgeon General Jerome Adams for allegedly violating Mayor Kirk Caldwell’s emergency order in August when he was out here to help the state get their struggling testing program up and running. Adams’ attorney stated that “this case continues to be an embarrassment to this state and the good people of Hawaii.” Ironically, the police officer that cited the U.S. Surgeon General is one of the officers being investigated of overtime abuse. Apparently, Jerome Adams’ violation was much more egregious that the other 58,000 cases that have been dismissed.
Honolulu Police Chief Susan Ballard is taking heat over some of her officer’s overtime pay according to Civil Beat with some officers making more than $200,000 per year in salary and overtime over the past three years while the Honolulu Police Department’s (HPD) crime-solving rate has declined. HPD declined to provide overtime data for certain officers of interest even though the data is shared by other city police departments around the country. Tommy Waters, the new chair of the City Council found it ironic that Ballard speaks about the importance of transparency yet would not release overtime data. He will ask the council’s new budget committee chair to investigate the overtime spending.
Former Deputy Prosecutor Katherine Kealoha was sentenced to 13 years in prison and ordered to pay $455,685 in restitution and her husband, former HPD chief Louis Kealoha to seven years in prison and ordered to pay $238,199 for efforts to steal proceeds from Katherine’s grandmother and framing her uncle, and for stealing money from two children for whom she was responsible for managing their finances. Two Honolulu Police Officers were sentenced for trying to frame Katherine Kealoha’s uncle with a staged mailbox theft using HPD resources.
The University of Hawaii (UH) Warrior football team has had an up and down three-win, four-loss season against their conference foes with all opponents currently having more wins than losses except winless New Mexico. UH recently lost to unbeaten San Jose state after beating then undefeated Nevada at Aloha Stadium on Thanksgiving weekend and suffering two losses against undefeated Boise State and 3-2 San Diego State. The University of Hawaii (UH) Warriors football team finished their season with a 28-14 victory over the University of Houston (UH) Cougars in the New Mexico bowl. The UH Warriors were 5-4 in coach Todd Graham’s first year.
The nation’s third oldest continuously operating community theatre has started building a new venue to replace the 87-year-old Diamond Head Theatre building in 2022. The new state-of-the-art theatre has taken 13 years of planning followed by fundraising and permitting. The $24 million facility will maintain a roughly 500-person seat-capacity, have a bigger stage, larger seats, more bathrooms, better air conditioning, larger dressing rooms, and additional classroom space. The theatre started in 1915 as the Honolulu Community Theatre and the successor organization, Diamond Head Theatre, started performing in its current location in 1952. The current building was originally built in 1933 to show movies for Army personnel stationed on Oahu and lacks the infrastructure most commercial theatres have.
A veteran Hawaii ecologist and his team at Arizona State University’s Center for Global Discovery and Conservation Science based in Hilo tweaked a laser-guided imaging spectroscopy system, essentially a high-tech camera, to penetrate water up to 70 feet to detect chemical signatures of both live and dead coral. Researchers started flights at the beginning of the year to map coral reefs off the coast of Hawaii’s populated islands over a period of 30 days. The new technology was able to take detailed shots of living coral reefs up to a depth of 50 feet. The mapping shows heavy degradation of reefs off Oahu shores and other populated coasts in Hawaii due to overfishing and two major coral bleaching events in 2015 and 2019 due to high ocean temperatures. In some good news, the team also documented some spectacular reefs that could warrant protection and others that are good candidates for rehabilitation. The maps are posted on the website https://hawaiicoral.org under the tab “Coral Maps” and clicking “Hawai’i GAO Maps.”
Hawaiian Islands Humpback Whale season officially started in November and the first humpback whale was spotted off Maui on October 8th. Scientists and environmentalists are hoping for a rebound in sightings and recorded whale songs after several years of decline. The numbers of returning whales to the island chain has grown from an estimated 895 mammals in the late 1970s from 8,000 to 12,000 today. Commercial whaling was banned in 1971 and the number of whales has been growing about 6% per year. Hawaiian Islands Humpback Whales were taken off the endangered species list in 2016. Biologists have been puzzling over the lower numbers recently and hypothesize that El Nino, a warm phase in the Pacific Decadal Oscillation, and an extreme marine heatwave known as The Blob disrupted the nutrients that krill eat forcing the whales to look elsewhere for food.
We recently started a podcast covering our monthly email newsletters. You can find the podcasts on iTunes and Spotify or our website: https://stott-real-estate-inc-monthly-newsletter.simplecast.com/episodes.
Odds & Ends
New Website: Stott Real Estate, Inc. has spent the past six months developing a new real estate website (www.stott.com) that we hope you find easy to use and helpful. We found a service provider that offers a state-of-the-art home search feature and helped create an interactive map of Oahu on the home page from which to start your searches. The website also allows us to continually add content that we hope you find useful, educational, and in some cases, entertaining.
The website breaks down areas of interest based on the type of information or services that you are seeking. The six areas include information about Stott Real Estate, Inc, seller information, buyer information, property management information, renting information for tenants, and real estate news.
The news section contains past monthly email newsletters, quarterly Oahu Updates, and you may download and print out copies of the Oahu Updates. Our monthly statistics page is a recent addition that we hope some find useful. We refer to this information monthly in our email newsletters and the page allows you to look at the actual reports in greater detail.
We hope you find that our new website is a valuable source of Oahu residential real estate information. Our goal is to provide our clients the necessary information to make well-informed decisions related to residential real estate. We may send you a short survey in the future requesting your feedback and hope to hear from you.
Mortgage Forbearance: According to the Mortgage Bankers Association, there are approximately 4.2 million homes in forbearance. The Coronavirus Aid, Relief and Economic Security (CARES Act) allowed homeowners with a loan backed by Fannie Mae, Freddie Mac, the Federal Housing Administration (FHA), the U.S. Department of Agriculture (USDA), and U.S. Department of Veterans Affairs (VA) to request forbearance for up to a year due to financial hardship. Obtaining forbearance should not reduce your credit score, but there are negative consequences to your credit worthiness.
Organizations and government agencies that insure most mortgages will not allow U.S. homeowners to refinance a mortgage that is in forbearance. If you are in mortgage forbearance and have a Fannie Mae or Freddie Mac backed mortgage, then you can refinance your mortgage once you end your forbearance and you make three consecutive mortgage payments. If you have a mortgage backed by FHA, USDA, or VA, call your mortgage provider and ask what options are available so that you can refinance in the future.
You will also be unable to obtain a new mortgage if you are in forbearance. Therefore, if you are looking to conduct a 1031 exchange and buy a new investment property with a mortgage, you will not be able to qualify if you have any mortgages in forbearance. There are strict timelines that must be met and a delay in obtaining financing could result in you failing to successfully complete the 1031 exchange and having to pay capital gains taxes.
Saving Time: Time is a precious commodity and there is only so much time every day to accomplish your goals, both short-term and long-term. There are many ways to save time and one of the best ways is to leverage your time. Hiring experts may cost some money and the reason people hire experts is that the expert can accomplish the project or task quicker and for less money. There are times to do it yourself (DYI) and times to hire someone and a little self-reflection may be in order.
A perfect example comes to mind. Tim and Tracey purchased their first duplex and had visions of doing all the repairs themselves to save money. One of the first projects that they tried to tackle was a bathroom ceiling repair. It turns out that properly installing drywall requires the proper tools and skill which both Tim and Tracey lacked. Their hours of toil and frustration were rewarded with a terrible looking bathroom ceiling and they eventually hired a professional to redo the job properly. What a waste of time and energy. Try learning from Tim and Tracey’s mistakes and hire skilled people when you lack those skills and don't have time to learn how to finish the task properly.
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. If you provide us your e-mail address, we’ll e-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. You can visit www.stott.com/sellers/1031-exchange and www.stott.com/sellers/harpta.
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 in two different states. 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 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 must 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. Your personal residence or a second home does not qualify. You could rent the new property first so that it qualifies as investment property and then occupy it yourself. Many of our clients 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 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 before 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 are 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 minus closing costs. 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 for 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.
a. 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. You are locked-in to whatever has been identified as new property on the 46th day.
b. 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. 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 20% 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 to be eligible for the exclusion. The owner still needs to rent it at least one year so it qualifies for the exchange and then have it be their principal residence for at least two years. The exchanger also must pay depreciation recapture on depreciation claimed (after May 6, 1997) while the property was a rental.
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 1/1/93 for $200,000 and rents it for 18 years until 1/1/11 when she occupies it as her principal residence. Two years later, on 1/1/16, Mary sells the property for $450,000 and has $250,000 of gain.
The non-residence use of the property by Mary prior to 1/1/09 does not apply to the Housing and Economic Act of 2008. 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 1/1/16 Mary will have owned it for a total of 23 years. Therefore, the fraction for non-resident use is 2/23. Or, the taxable gain is $250,000 x 2/23 or $21,739 versus having no taxable gain if she was an owner occupant the entire time after 1/1/09.
In my example, I 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 3/5 or 60%. However, if it is rented for only one year and then occupied for four years, the non-resident use would only be 1/5 or 20%. 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. Others have identified regions with better cash flow and will exchange a property with poor cash flow with one that provides better cash flow. Some may just want to diversify their risk by owning different types of real estate and in different locations. 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. Call us (808-254-1515) or 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.