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Quarterly Newsletter October - December 2021

| P r i n t   R e p l i c a |  The December median sales price for single-family homes was $1,050,000 (20.7% higher than December 2020) and for condos was $485,000 (6.6% higher than December 2020).  The number of single-family homes that sold dropped 10% and the number of pending sales dropped 8.9% as a lack of supply constrains the market.  The inventory of single-family homes dropped from one month of inventory in November to 0.8 months of inventory in December.  Demand for condos continues to increase with a 13.1% increase in the number of sales and a 16.7% increase in the number of pending sales.  Median sales prices failed to set new records for the fourth month in a row despite extremely low inventory as housing affordability becomes an issue with buyers.

 

Governor Ige welcomed domestic vaccinated visitors effective November 1st and international visitors in accordance to federal guidelines on November 8th.  The visitor industry has cautiously welcomed Ige’s announcement, however, they have pointed out that Mexico and other tropical designations are outperforming Hawaii because they do not have inconsistent and confusing social distancing restrictions.  The CEO of Pleasant Holidays stated, “people want to enjoy themselves when they are on vacation.  It’s still confusing in Hawaii.  They don’t know if they will be able to do the things that they want to do once they get there.”

 

The University of Hawaii Economic Research Organization (UHERO) forecasts Hawaii muddling through another year as the state continues to struggle with the COVID-19 pandemic.  UHERO sees potential increased international tourism and federal handouts as the only engines for growth in 2022, both of which are beyond the state’s control.  Many families will struggle as high home prices in the form of rents or sales prices will hit budgets hard while federal pandemic related subsidies end.  UHERO predicts state gross domestic product figures will not return to 2019 levels until 2023 and visitor spending will not return to 2019 levels until 2025.

 

A Mixed Plate of Talk Story

 

Effective January 6th, landlords can start the eviction process for tenants that are one or more months behind in rent.  The local news has highlighted that there has not been a surge of evictions because there were few tenants that owed more than three months of past due rent.  Stott Property Management, LLC (Stott PM) manages about 380 accounts and has only completed one eviction of a tenant more than four months behind in rent and recently completed a few state-required mediation of tenants owing two or more months of past due rent.  One tenant voluntarily vacated after he could not meet the mediated payment plan.  Stott PM is currently working with a few more landlords now that they can gain possession from struggling tenants.  The number of evictions will start accelerating as some tenants fail to pay the past due rent owed and the bills come due.  Several Hawaii investment property owners are ready to abandon Hawaii’s rental market after experiencing Governor David Ige’s disregard for their economic struggles.

 

A combination of chronic federal underfunding of the military over the past thirteen years, bureaucratic bungling, and callousness has seriously damaged the U.S. Navy’s reputation within the ranks and may have caused serious environmental harm to Oahu’s water system.  Several environmental organizations including the Sierra Club have been agitating to shut down the Navy’s 20 underground fuel tanks under Red Hill because they sit just one hundred feet above Oahu’s aquifers and a 2014 fuel leak raised structural integrity concerns.  The Navy quietly shut down the Red Hill shaft on November 28th after military families started complaining that their tap water smelled like fuel or chemicals and several people and pets started to get sick.  The Board of Water Supply shut down its Halawa shaft that delivered 20% of Urban Honolulu’s water as a precaution on December 3rd.  The state Department of Health ordered the Navy to suspend operations at the Red Hill Bulk Fuel Storage Facility on December 6th, clean up the contaminated drinking water, and develop a plan to drain the fuel from the twenty underground storage tanks.  Neither the Navy nor the state Department of Health (DOH) notified the public of the contamination even though samples from July through September showed fuel contamination.  The Navy claims to have informed the DOH of the water testing results and the DOH failed to notify the public as well.  Both the Navy and the DOH were refusing to answer questions concerning how early both organizations knew of the problem and why they waited until December 2nd to notify the public.  The Red Hill shaft provided water to an estimated 93,000 people and more than a dozen elementary schools.

 

The Navy is scrambling to clean up their tap water system contaminated from spilled jet fuel from the underground Red Hill fuel storage facility and initially spread the pollution to other parts of the environment.  The Navy originally asked residents to run their water and flush toilets to remove contaminants while some residents complained of becoming overwhelmed from fumes.  The state Department of Health issued a cease-and-desist order when they learned that the Navy was flushing water from hydrants and failing to follow state guidance.  Apparently, the Navy has not seen the signs at runoff drains saying that the water flows to the ocean.  The Navy has belatedly hired a civil engineer from Purdue University and flew in activated charcoal filtration systems to remove the jet fuel.  The effort includes a Navy dive team that is skimming contaminants from the surface of the Red Hill water shaft.  More than 3,000 people are currently living in Waikiki hotels while the effort to clean up the fuel spill continues.  Engineers anticipate the process of flushing the military housing plumbing system will take 30 to 45 days.

 

A security fellow at the Truman National Security Project has described the Navy’s Red Hill water crisis as a problem that is years in the making.  He has accused military brass and national government figures as lazy and negligent for solely focusing on pricey high-tech weapons systems and ignoring the aging infrastructure needed to support and maintain the military’s weapons systems and personnel.  It will fall on Congress to fund the project to replace the underground facility if the state of Hawaii gets its wishes.  The latest version of Congress’ annual defense bill has a provision directing the military to find alternatives to the 80-year-old Red Hill Bulk Fuel Storage Facility.  The state Department of Health concluded its contested hearing on December 28th by deciding that the Navy must comply with an emergency order to empty the underground fuel tanks until it can upgrade the tanks to prevent future spills or build a new storage facility that does not threaten Oahu’s water supply.

 

A Honolulu Civil Beat article spells out a major reason for Governor Ige’s decision to extend his social distancing requirements and maintain some of the strictest restrictions on travel, dining, sporting events, and gatherings.  The state’s chronic shortage of nurses grew significantly worse during the pandemic.  Almost 5,000 nurses left the field between 2019 to 2021, shrinking the number of nurses from 33,410 to 28,548.  Hawaii does not sufficiently fund the state’s nursing schools and despite thousands of young people interested in nursing, less than one-half of the qualified applicants were admitted in 2021.  1,393 people were deemed qualified, yet only 636 were admitted for instruction.  Only 24 of 94 qualified applicants were admitted to the University of Hawaii (UH) Maui College.  Despite the crisis, UH has a hiring freeze in place and cannot hire additional nursing instructors.

 

In a refreshing twist, Mayor Rick Blangiardi, has resisted calls for new social distancing restrictions and asked Oahu residents to take responsibility and use their own judgement to navigate the Omicron variant surge.  The record number of daily cases has exposed the failure and futility of Hawaii’s Safe Travels Program to prevent the spread of COVID-19 while creating bottlenecks and hassles for people flying to the islands.  Many airlines have suspended their bracelet programs designed to skip the processing lines at Hawaii’s airports due to costs and employee shortages.  Tim and Tracey recently had to wait 90 minutes for their daughter to receive clearance and meet them at baggage claim.  The long lines forced Hawaii airport workers to pull luggage of the carousel to make room for the next flights bags while visitors were waiting in the Safe Travels queue.  Governor David Ige does not plan on any changes to the program as he continues to evaluate the program and “follow the science.”

 

The Hawaii Supreme Court struck down a controversial legislative tactic coined “gut and replace” in early November.  The term applies to a common legislative practice of deleting a bill’s contents after it has gone through the three required hearings and replaced with unrelated legislation.  The tactic was recently applied this past April when a bill associated with an aerospace matter was suddenly replaced with new language that eliminated the Hawaii Tourism Authority’s annual tax allocation and allowed counties to impose an additional 3% to Hawaii’s Transient Accommodation Tax on visitors.

 

The Thirty Meter Telescope (TMT) has been named as one of the U.S. Government’s top funding priorities along with its cousin, the Giant Magellan Telescope, planned for construction in Chile.  That funding may not be of any use unless the state can resolve the construction impasse with Native Hawaiian protestors who do not ever want TMT to be built on Mauna Kea’s summit.  The latest Mauna Kea master plan calls for a maximum of nine observatories at the summit by the end of 2033.  The plan calls for retiring four observatories and five current observatories if the Thirty Meter Telescope (TMT) gets built.  The plan also limits the of number parking and gathering places that that could replace decommissioned sites.  A separate effort by the state House of Representatives calls for a new management structure consisting of fifteen volunteers which excludes the University of Hawaii (UH).  Some people, including a group of Native Hawaiians, have accused UH of mismanaging the activity on the summit and polarizing the community.  Public remarks opposed to UH’s continued management of leased land claim Mauna Kea is sacred, observatories have desecrated the summit, and UH has ignored the concerns of the public including Native Hawaiians.  Public remarks in favor of UH’s involvement stress the need to continue activities in advancing astronomy, education, and scientific research world-wide.

 

Honolulu’s Department of Planning and Permitting (DPP) is once again delaying needed infrastructure.  This time, the bureaucracy’s red tape is miring Hawaiian Electric’s (HECO) Battery Bonus program where participants will receive one-time cash payments of $850 per kilowatt up to $4,250 for five kilowatts of battery storage to existing rooftop solar systems that will export energy to the grid during peak evening hours.  The extra battery storage is needed when Oahu’s coal plant is retired in September.  Contractors dropping off permit applications were greeted by a sign that read the building permit process is backlogged by eight weeks and payments are behind thirteen days.  Solar companies have fielded thousands of phone calls from interested people yet only 31 applications were approved in August and 143 applications were approved in September.  The Hawaii Solar Energy Association wrote a letter dated September 29 to Mayor Blangiardi stating that rolling blackouts will occur if the continued delays result in insufficiently available backup power when the coal plant retires.

Queen’s Medical Center is planning a $1 billion expansion of its Punchbowl Street campus in response to intensive care unit (ICU) capacity constraints exacerbated during the patient surge from the COVID-19 delta variant in August and September.  Queen’s ICU has been running at full capacity over the past six years and had to scramble to modify other spaces to care for an additional thirty patients suffering from COVID-19.  The expansion will double Queen’s ICU capacity and take place in four phases over the next 15 years.  The project involves tearing down buildings, some of which are 80 years old, and replacing them with larger, modern structures.  Queen’s submitted plans to the City and County of Honolulu for initial approvals to start next year and Hawaii can only hope that the city bureaucracy will prioritize approvals so that the critically needed infrastructure project does not suffer the same delays that is hamstringing HECO’s Battery Bonus program.

 

UH plans on expanding its Clarence T.C. Ching Athletics Complex, the home of on-campus football by a couple of thousand for next season.  The stadium currently allows seating for about 9,000 fans and UH plans to increase capacity to over 15,000 by the start of the 2023 season.  UH averaged 5,217 fans during the last two games but was unable to serve food and alcohol due to pandemic related restrictions and children could not attend.  The student section was rowdy and full the last two games providing an encouraging sign for next year.  UH wisely is investing in the on-campus venue versus waiting for the state’s new Aloha Stadium.

 

Volunteers who dedicated thousands of labor hours and hauled more than 600,000 pounds of material up Koko Crater Trail’s incline (Stairmaster from Hell) repaired the final step more than 1,000 feet up.  Kokonut Koalition members lifted sandbags, buckets of gravel, lumber, and hardware over 10 months to complete a project that was expected to take two to three years.  Maybe the coalition can tackle Honolulu’s rail project next.

 

Hanauma Bay Nature Preserve announced that it requires out of state residents to pay the admission fee online when making their reservations effective December 1st.  Tickets to the incredible bay can sell out within five minutes of becoming available and the city parks service wants to reduce the number of no-shows.  The City and County of Honolulu implemented the reservation system to limit the daily number of visitors to the preserve to prevent further degradation of the bay’s coral ecosystem.  Hanauma Bay Nature Preserve is trying to ensure the limited number of times available are most efficiently allocated.  Tim and Tracey recently swam in Hanauma Bay twice after more than a decade and marveled at the diverse marine life within the protected bay.

 

Investment Property Business Cycle

 

Like all businesses, a rental property has a life cycle that investors can plan for or ignore at their own peril.  Proper planning and execution start at day one and must continue throughout the duration of the investment.  This article outlines a framework that an investor seeking passive income can follow to build an investment real estate portfolio that will continue to provide reliable cash flow year in and year out.  The different real estate strategies for making money range from fix and flip to buy, rent and hold with a myriad of modifications in between.  Tim and Tracey do not engage in house flipping and therefore, have no expertise in that discipline.

 

Successful investing always starts with the initial asset purchase.  Annual rent that considers a realistic vacancy rate should provide positive cash flow after paying for financing (a mortgage in most cases), property management fees (a passive investment), insurance, taxes, repairs, and maintenance.  If the property’s expenses exceed the property’s revenue, then you are using your wages from your job to subsidize your “passive investment” and reducing your disposal income versus increasing it.  In other words, the new investment will make your financial life harder instead of easier.  The goal for most investors is to generate money so that they can eventually buy more freedom and time.

 

In the early years of all successful businesses, cash flow generated from the business is reinvested in the business achieve self-sustaining scale.  The same goes for an investment real estate portfolio.  The initial positive cash flow should be plowed back into the property in the form of maintenance reserves and paying off the financing as needed to provide a financial cushion should the real estate market turn south.  There are some that argue reducing your leverage will hamper or delay the growth of your portfolio and result in paying more taxes than necessary.  Tim and Tracey have helped many over-leveraged people that have been burned by making financial decisions focused on reducing taxes versus managing risk.  Once the first investment has the needed maintenance reserves and appropriate leverage, then the investor can and should look for new opportunities.  The process can be accelerated by injecting new capital into your investment real estate business as part of your overall investment strategy.  Tim and Tracey spent the first twenty years using the positive cash flow and providing fresh capital from their earnings to increase their real estate portfolio.

 

When the business is throwing off more cash (desired outcome) than you can effectively invest back into the business, then pay yourself and either deploy the cash in an investment that generates better returns or enjoy spending it.

 

One error that some real estate investors make is failing to recognize, acknowledge, and resolve negative cash flow from a rental property that has little upside.  Some revenue shortfalls can and should be resolved by pulling cash out through a refinance to pay for a remodel that will generate sufficient cash flow.  If refinancing and remodeling does not solve the negative cash flow problem, then the real estate investor should sell the property and deploy the funds in an investment that has a higher probability of providing positive returns.  Stott Property Management, LLC manages several undercapitalized rental properties that attract problem tenants and generate poor cash flow.  The owners cannot afford to make the necessary repairs to attract better tenants and the resulting negative business cycle creates financial and sometimes personal distress.  In some cases, owners hold on because they do not want to pay capital gains taxes.  If that is the case, then conduct a 1031 exchange.  Do not suffer negative cash flow over an extended time for tax reasons.  It just does not make sense.

 

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.

 

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.  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 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 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 $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 1/1/16 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 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. 

 

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