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Quarterly Newsletter October - December 2022

P R I N T  |  R E P L I C A  The December median sales price for single-family homes was $1,049,500 (0.5% lower than December 2021) and for condos was $502,500 (3.6% higher than December 2021).  Demand continues to remain drastically lower than 2021 numbers with closed sales dropping 46.6% lower for single-family homes and 39.3% lower for condos and pending sales dropping 47.3% lower for single-family homes and 45.2% lower for condos.  The supply of single-family homes almost doubled, and the supply of condos rose 23.7%.  There is currently 2.1 months of single-family homes inventory and 2.2 months of condo inventory.

 

A recent Wall Street Journal article predicted more difficulty in the residential housing market for several reasons on both the sales and rental sides of the market.  Mr. Timiraos, the author, argues that the COVID-19 pandemic pulled forward the U.S. household formation growth percentages when more people wanted to live without roommates and more knowledge workers bought homes with room for home offices.  Timiraos estimates that normal household growth would have been half of the rate over the past 30 months if the pandemic had not occurred.  The housing market will face significant headwinds as a result of people seeking roommates to help pay for soaring rents coupled with the Federal Reserve’s rapid interest rate increases at the end of last year.  Mortgage rates have increased from about 4% in March to 6.3% at the end of December after peaking about 7% in October.  Fannie Mae economists predict that 2023 existing home sales will be below the average yearly home sales during the real estate bust from 2006 to 2011.  The Federal Reserve has raised rates seven times to a target range of 4.25% to 4.5% and economists predict further rate hikes in 2023.

 

Tim and Tracey wish you a Happy New Year and have set goals to pay off an investment property mortgage and buy another duplex.  What are your goals?  Please email us at [email protected] if you would like some help in attaining your 2023 goals.

 

A Mixed Plate of Talk Story

 

Steep property tax assessments are causing some Oahu property owners to question the values despite evidence that the buoyant real estate market has made their homes that much more valuable.  Tim fielded at least five calls from clients who wanted to protest the values but could not because the data failed to support their arguments.  Tracey recently spoke with  owner of a leasehold condo whose assessed value rose from $657,600 to $808,600 this past year.  Tracey looked at last year’s sales and told the owner that the assessment was below the 10% threshold to protest the value.  Tracey further advised the owner that the assessed value was approaching $1,000,000 where the tax rate jumps for "Residential A" property from 0.35% for every dollar to 0.45% up to $999,999 and 1.05% for every dollar at $1 million and above.  The letters to the editor at the Honolulu Star Advertiser have been filled with complaints about the assessments.  Mayor Rick Blangiardi pointed the finger at rich mainlanders arriving with boatloads of cash driving up prices and briefly mentioned the lack of housing inventory.  It apparently does not matter that study after study points to the red tape coming from state and county government contributing most to this “crisis.”

 

Governor Josh Green announced that he will take the lead on eliminating the state’s dysfunctional building regulations that prohibit affordable housing construction.  Unfortunately, he did not address the state’s role in hindering housing construction in general, the source of the lack of supply resulting in unaffordable rents and prices.  Instead, he has invited the legislature to spend more taxpayer money to build the stock of affordable housing.

 

Green has reversed David Ige’s decision and restarted the public-private development of the New Aloha Stadium.  He would also like to shorten the timeline of the new multi-purpose stadium surrounded by mixed-use real estate development by a year.  Green would like the stadium ready before the estimated 2027 completion date.  Since Hawaii has recently shown that it is unable to complete large projects on time and within a budget, the public-private partnership makes sense.  About 70 acres of the 98-acre project would be used for housing, hotels, offices, and retail spaces.  The state legislature set aside $350 million for the project via a more traditional state-built contract.

A federal judge has halted the City and County of Honolulu’s 90-day short-term rental law until April 26, 2023, in response to the Hawaii Legal Short-Term Rental Alliance’s lawsuit declaring the new law unconstitutional.  The lawsuit alleges that the new law interferes with the owners’ vested rights to own and rent property and violates state zoning law. The plaintiffs argue the bill caused immediate and devastating financial harm for property owners who purchased investment property and legally rented their property for 30 to 89 days.  The city started enforcing parts of the new law on October 24th that were not subject to the federal judge’s ruling.  Despite DPP being understaffed by 80 people, the mayor is dedicating 7 full-time inspectors to his endeavor.  Those seven full-time inspectors might be better utilized helping work through the backlog of 8,000 permits.  The Honolulu Board of Realtors has provided guidance to landlords regarding the judge’s ruling:

 

  • 90-day or longer leases are exempt.
  • Month-to-month leases, written or unwritten, are exempt since their tenancies are essentially indefinite per the state of Hawaii’s landlord tenant code.
  • Purchase leases like the early occupancy agreement for buyers and post occupancy agreements for sellers are exempt.

 

Changes to the City of Honolulu’s short-term rental program requirements as late as October 21st have frustrated legal short-term rental operators and bogged down the city’s online registration program.  The rushed website started accepting applications only one day prior to the new law’s effective date.  Per standard operating procedure, the DPP hotline was unable to handle the sixty phone calls from frustrated owners who were seeking answers and help with the cumbersome prospect.  DPP plans on enforcing fines on owners trying to follow the new law even though they are causing the delays claiming, “their hands are tied.”  Investors who would like to continue renting short-term may register at the site below:

 

https://www.honolulu.gov/dpp/permitting/short-term-rentals.html

 

An October 24th front-page article in the Honolulu Star-Advertiser paints a bleak picture due to the new short-term rental law effective October 24th.  A couple who cleans Waikiki vacation rentals are holding their breath for fear of further economic hardship.  They used to mainly clean single-family homes until the 2019 passage of Ordinance 19-8.  Paul Brewbaker, a leading economist in Hawaii, states, “short-term rentals were a growing part of Oahu’s only factory.  If tourism production slumps, Oahu’s future looks a lot like Detroit in the 1970s after the closure of auto plants.  I don’t know how it isn’t obvious that some people will be way worse off.  A further decline could lead to more people leaving Oahu.  When Detroit’s economy shrank, people left.”

 

The New Year brought more firework related injuries and more calls from first responders to tighten enforcement.  The 37% drop in permits failed to predict the increased aerial pyrotechnic activity on Oahu and corresponding increase in firework related injuries requiring hospitalization.  The Honolulu Advertiser placed a front-page photo of smoke over Honolulu Harbor reminding Tim and Tracey of the New Years Eve nights driving home at 10 miles-per-hour due to the smoke that limited visibility to a few feet.  The smoke caused people with difficulty breathing to call for help and contributed to 11 traffic accidents.  It appears Honolulu revelers have fully emerged from their pandemic slumber.

 

A retired DPP plans examiner pleaded guilty to accepting $100,000 in bribes to pre-screen plans and expedite permit approvals.  The examiner set up a business to help accept bribes and told the FBI that the $100,000 was a loan from an architect.  The examiner had retired in 2017 and was indicted March 17, 2021.  The architect pleaded guilty on April 7, 2021, for paying more than $89,000 in bribes.  The architect will be sentenced on December 1st and the examiner will be sentenced on March 9, 2023.  

 

A preservation group, Friends of the Haiku Stairs, is trying to block the removal of the stairs, known as the Stairway to Heaven, and build support to reopen the popular hike.  The group would like to resurrect the city’s plan to provide legal access to the stairs and eventually provide funds to maintain the stairs.  The removal was scheduled to be completed by the end of this year and cost $1.3 million to remove by helicopter.  The project is expected to begin in 2023.  Proponents of the stairs argue that it will cost much more to remove, the removal will cause environmental damage, and hikers will continue to access the summit by the more dangerous remaining path or summit hike from Moanalua.

Mauna Loa showed of a new eruption after 38 years of quiet in October.  Elevated seismic activity and ground swelling suggest that magma may be filling the mountain.  The Hawaiian Volcano Observatory started issuing daily updates on 10/6/2022.  40-50 small earthquakes have began shaking the mountain daily at a rate of two to three per hour.  The Hawaii County of Civil Defense has been helped the state develop an evacuation plan should the mountain erupt.  The lava is fast moving, and it only took three hours to reach the Kona coast in 1950.  The Hawaii Volcanoes National Parks closed the summit since evacuations are very difficult at an elevation of 14,000 feet.  Moana Loa erupted for the first time since 1984 at about 11:30 on 11/27/2022 providing spectacular views of lava fountaining in a growing summit lake.  The vents are on a level part of the mountain and the lava is headed towards Hilo.  Scientists describe the path as the best possible route placing Hilo far from danger.  If it continues, the lava could take a week before hitting the outskirts of Hilo.  The Mauna Loa eruption is no longer considered a threat to the highway that crosses the Big Island stopping 1.9 miles from the road.  The last fissure has stopped feeding the 12-mile-long lava flow.  While the current lava flow is considered over, the eruption was not yet considered dormant and could restart at any time and in any direction.  Scientists at the Hawaiian Volcano Observatory later announced that the eruption ended on December 13th.

 

A recently completed study by Hawaii scientists documented the benefits of ocean sanctuaries like the Papahanaumokuakea Marine Sanctuary.  The study started in 2016 and documented a 54% increase of yellowfin tuna, a 12% increase of bigeye tuna, and an 8% increase of various reef fish in and near the sanctuary.  The study offers good news to the tuna fishing industry who have resisted creating expansive marine protected areas due to the loss of fishing grounds.  Scientists hope the study will help promote better management of our ocean resources.

 

Downed seabirds may have a new “Buddy” to help them out in their time of need.  Turtle Bay is testing a program using specially trained dogs to find downed seabirds hidden from their human rescuers.  The dog teams have found 90% of hidden seabird carcasses and conservationists hope that translates to dogs finding live birds before they are hunted by predators.  

 

A new study by University of Hawaii found that the diversity of algae living symbiotically with the coral varies significantly from one part of Kaneohe Bay to another.  Algae provide most of the energy coral needs to survive. Researchers collected and logged 600 rice coral colony specimens throughout Kanoehe Bay and found that two types of algae are commonly found in the coral.  Cladocopium is more broadly present and heat resistant Durusdinium is found in coral at shallower depths and provides the coral added resistance to heat stress.  Coral in the extreme North and South of the bay showed lower levels of the heat resistant strains than the rest of the bay since it receives less daily sunlight.

 

Hawaii spinner dolphins are at risk of disease by the same bacteria threatening the Hawaii monk seal, Toxoplasmosis.  Feral cats host the bacteria, and the eggs are spread by the cat’s feces.  The bacteria can survive up to two years in the environment and are carried to the ocean by rainwater.  Two dolphins have been killed by Toxoplasmosis over the past decade and the disease has been found in 60 dolphins over the past thirty years.

 

Hawaii researchers tagged a nine-foot tiger shark that sent back thousands of reports on the shark’s location and ocean temperatures.  The shark swam in depths of more than 1,600 feet and in waters ranging from 50 to 80 degrees Fahrenheit.  The trial provides proof that data can be collected below the surface where satellites are unable to measure.  Researchers hope the additional data will better guide conservation efforts.

 

A study published December 22nd provides strong evidence that the magma chambers of Mauna Loa and Kilauea are connected deep underground.  The theory explains why both Mauna Loa and Kilauea eruptions ended about the same time.  The pancake like structures at depths of 10 to 100 kilometers, called sills, channel magma both laterally and upward supplying the two volcanic chambers.

The U.S. Fish and Wildlife Service announced that 275,000 acres on Kauai, Maui, and the Big Island will be designated critical habitat for the iiwi, the most threatened of the Hawaii honeycreepers.  An estimated 600,000 of the red birds with curved beaks and black wings live on the Big Island (90%), Maui (9%), and Kauai (1%).  The designation of land is in response to a lawsuit by the Center of Biological Diversity.

 

Odds and Ends

 

Maximizing Exposure of Your Vacant Property:  Gone are the days that you could quickly post a Craigslist Ad with a bunch of photos and wait for the phone to ring and emails to flood your inbox.  Most tenant prospects avoid Craigslist because it is not smart phone friendly, and it has the reputation for hosting rental scams.  Stott Property Management, LLC still does advertise on Craigslist, but receives most inquiries from the following sources:

 

Facebook Marketplace

Instagram

Zillow

Zumper

Stott Property Management, LLC Website

Lovely

Apartments.com

Apartment List

 

Facebook Marketplace has provided a tremendous boost to demand for our vacant properties helping maximize rents and minimize vacancy rates.  Last week, we reached 206 potential tenants.

 

Tenant prospects can not only request a showing by visiting our website, we text them the date and time of the showing, remind them of the showing the day prior, they can fill out an application on their smartphone, upload documents, and sign the lease on their smartphones.  The convenience has been a game changer for both our tenants and our clients.

 

We relearned the age-old lesson of hiring competent professionals two years ago.  Tim and Tracey read “Money, Master the Game,” by Tony Robbins.  He promoted a company, Creative Planning, that combines Investment Portfolio Management, Tax Planning, and Legal Services at competitive rates.  The skills and knowledge they brought to the table could not be replicated by us.  They created Tim and Tracey’s investment property LLC, employ tax loss harvesting, and prepare their income tax returns every year.  Tim tried to do these things on his own and failed.

 

Do you have the time to do the following:

 

Post ads on all these sites.

Show the property during normal business hours.

Run credit checks.

Obtain previous landlord reference checks.

Fill out a detailed property condition form.

Write up a lease.

Inspect the property annually.

Determine the market rent annually.

Answer repair requests 24 hours per day 7 days per week.

 

Even if you can handle one property, can you manage 19?  Tim and Tracey learned long ago that they could not continue to purchase money making properties thousands of miles away without hiring professionals.  

 

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, email us at [email protected] 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 two years 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 sale 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 two years 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.  If the property has been used as a rental after 2009, and the owner has moved into the property two of the last five years, then the capital gains exclusion is reduced by the following equation:

 

Number of days taxpayer rented property / Number of days taxpayer owned property X Gain

 

Example:  Married couple bought their Oahu home on 1/1/10 for $400,000 and rented it for nine years until 1/1/19 when they occupy it as their primary residence.  On 1/1/22, they sell the property for $1,000,000 and have $600,000 in gain.  (Note:  This is a simple example and did not incorporate buying costs, improvements or selling costs, etc. in gain.  Years instead of days have been used to make the example easier to follow.)

 

They have nine years of non-residence use that applies from 1/1/10 to 1/1/19 when they then occupied it as their primary residence for three years.  The owned it a total of twelve years.  Their taxable part of the gains is $450,000 (9/12 X $600,000 = $450,000).  The couple can use $150,000 ($600,000 - $450,000 excluded gain = $150,000) as their exclusion, not $500,000.  They owe federal and Hawaii taxes on $450,000 of gain.

 

If the sale of the home results in capital gains that exceed the allowed exclusion, then the taxpayer must report the taxable gain and pay the appropriate capital gains taxes.  Consult with your CPA.

 

This calculation does not include Hawaii depreciation recapture for both federal and Hawaii.

 

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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