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Quarterly Newsletter October - December 2023

| PRINT REPLICA |   The December median price for single-family homes was $996,500 (5.1% lower than December 2022) and for condos was $510,000 (1.5% higher than December 2022). Demand continues to fall with 9.9% fewer single-family homes and 24.4% fewer condos sold this December compared to the same month last year.  Single-family home sales have fallen twenty-three consecutive months and condo sales have dropped for nineteen straight months. The number of available properties, both single-family homes and condos, appears to be stabilizing yet scarce.  There are still only 2.8 months of single-family home and 3.2 months of condo inventory.

National Home sales fell to a 13-year low in October and November sales rose slightly above October’s low due to lower mortgage rates. The Federal Reserve’s interest rate hikes have seized up the resale housing market and negatively impacted related businesses like furniture and home improvement stores.  The furniture industry and home improvement sector have experienced four straight quarters of falling sales resulting in fewer jobs. Employment related to real estate has stagnated and some real estate agents are reconsidering their career path, particularly after the court verdict that may impact the way clients pay Buyer’s Agents. Economists think that mortgage rates will have to drop at least an additional percentage before more sellers become willing to trade their currently low mortgage rates for a new home with a higher rate.  Some good news came in the form of growing new home construction and a rise in building permits.

Tim and Tracey wish you a Happy New Year and have set goals to pay off their businees line of credit used to finance two investment properties.  What are your goals?  Please email us at [email protected] if you would like some help in attaining your 2024 Oahu real estate goals.

 

A Mixed Plate of Talk Story

 

Paul Brewbaker presented to the Windward Region’s real estate agents in late August and provided updates on Hawaii’s economy, economic trends, and predictions for real estate in the long-term.  The biggest takeaways from his presentation include.

  • Hawaii’s overall economy has reverted to long-term trends following the pandemic disruptions.
  • Hawaii’s labor participation rate continues to drop about 5% per decade due to Hawaii’s aging population.
  • Oahu’s inflation rate has returned to the pre-pandemic average of 2.2% per year in 2023.
  • Total Oahu home sales will remain low due to higher mortgage rates.
  • Oahu’s real estate prices will return to an annual appreciation of about 2.2% higher than the inflation rate.
  • Hawaii’s gross domestic product growth has stabilized compared to the rest of the nation.  Hawaii GDP growth fell about 15% compared to U.S. GDP growth from 2018 through 2022.

A U.S. Court District judge issued a summary judgement granting the Hawaii Legal Short-Term Rental Alliance (HILSTRA) a permanent injunction against a provision of Ordinance 22-7 prohibiting home rental periods between thirty and 89 days for property owners who were following the 30-day minimum rental period before the laws effective date of October 23rd, 2022. HILSTRA successfully argued that the new law caused immediate and devastating economic harm to landlords and operators legally renting their properties.  The permanent injunction will make the thirty to 89-day ban on newer rental properties extremely difficult to enforce. The city has not decided if it will appeal the decision.

Soaring hurricane insurance rates are causing some condominium complexes to secure coverage that does not completely cover replacement costs. The rising costs are occurring despite Hawaii not experiencing a direct hit in 31 years because of the global nature of the reinsurance market. An association’s decision to reduce insurance coverage can make it difficult for home buyers to obtain mortgages and pay higher rates. A local insurance expert estimates almost four hundred condo complexes do not have full coverage including luxury buildings in Kakaako.

An article by Civil Beat summarized decades of action or lack of action resulting in the years-long slog many homeowners and contractors experience at the Department of Planning and Permitting (DPP) waiting on permit approval. Back in the 1970’s, a contractor could obtain a building permit the same day by walking plans to each DPP department for signatures and being able to fix issues on the spot when an experienced examiner pointed them out. A loss of institutional knowledge when experienced examiners retired, increased regulation, a failure to update technology, and the removal of face-to-face interaction has resulted in November 2022 permit times of 330 days on average for a residential permit and 420 days on average for a commercial permit.  DPP reported an average of a six-month delay in October, easy solar power permits have skewed the numbers since building permits still languish. DPP’s largest problem is hiring since people with an architecture or engineering background can make $20,000 to $50,000 more in the private sector and “don’t get yelled at as much.”  Additionally, the Honolulu City Council issued a rash of new regulations from 2016 through 2020 requiring DPP to establish a new department and additional review step. DPP’s director has received additional funding to hire people to reduce the backlog, however, contractors are still waiting “longer than ever” for a permit in the meantime.

 

A jury will decide the merits of a dispute between developer Howard Hughes Corp, developer of Ward Village in Kakaako and the Honolulu Authority for Rapid Transportation (HART) over the cost of the land HART seeks to build the rail project’s Kakaako station.  The estimated price tag is $200 million, and HART has already spent $23.3 million in legal fees as of 2021. Howard Hughes Corp. disagrees with HART about receiving “special benefits” and HART using the “special benefits” to calculate the amount paid for the land. HART’s “expert appraiser” valued the land HART wants to take from Howard Hughes Corp. at $14 million. There is no current plan to build the Kakaako station at the heart of the dispute after Mayor Blangiardi postponed the construction of the final 1.25 miles of the line because of cost overruns.

Joint Task Force Red Hill (JTFRH) announced it finished the gravity draining portion of the defueling operation of the Navy’s underground fuel tank facility on December 15th, 2023, removing almost 150 million gallons of fuel from the site.  The last tanker of fuel departed on December 20th for the Philippines, one of several U.S. sites in the Pacific chosen to receive the drained fuel.  Workers must pump about 60,000 gallons of remaining fuel and remove about 30,000 gallons of “sludge.”  JTFRH scheduled the removal of the remaining fuel by the end of January, six months earlier than planned.

Governor Josh Green announced a $150 million fund to help compensate family members of the 99 people killed in the Maui wildfires and to those survivors that have been severely injured.  Hawaiian Electric Company (HECO), the state of Hawaii, Maui County, and Kamehameha schools have contributed to the fund.  Each family is projected to receive $1.5 million if they agree to release the parties from liability stemming from the fires.  The program is voluntary, and families can opt to continue their lawsuits if they would rather seek higher claims from the defendants.  The state projects participants receiving initial payments between April and June 2024.

After two years and $7.8 million, the state is scrapping its effort to replace its 50-year-old Enterprise Financial System because the contractor could not meet the cost, schedule, or performance parameters because the state and contractor disagreed on the requirements.  Essentially, the state wanted a custom software package to support its “unique business practices” instead of using an off-the-shelf version of the software.  One vendor complained a major part of the problem is the state buys systems that have succeeded elsewhere and demand so many modifications the system becomes unworkable.  Software companies build software around best-known practices and most customization is a result of an organization’s resistance to change even when that change will improve operational performance.  The same contractor is struggling to implement a new software solution for the Department of Transportation who is also requiring extensive customization.  The state of Hawaii’s bureaucratic mindset has resulted in its failed Unemployment Benefits software.  The state is currently struggling to process 2,200 applications for federal disaster unemployment assistance of which 500 have been approved and a backlog of 15,161 regular unemployment claims of which 8,731 are currently being paid.

Contractors removed and packed up the Caltech Submillimeter Observatory telescope on Mauna Kea for shipment for Chile in December, the first of five telescopes scientists must decommission on the Mauna Kea summit to make room for the Thirty Meter Telescope (TMT). TMT construction remains in limbo as the National Science Foundation completes more environmental studies and the new Mauna Kea Summit Oversight Authority takes over management of the summit.

A Navy Poseidon P8-A overshot the runway at Kaneohe Bay Marine Corps Base and slid into Kaneohe Bay about 100 yards off the runway on November 20th.  There have been no known fuel leaks, and the Navy is working with Boeing to safely remove the plane from its resting place on a coral reef.  An underwater video shows the two parts of the plane resting on the reef and damage appears to be minimal.  The Navy started pulling the plane backwards onto the runway on December 2nd, 13 days after the plane slid into the bay.  The recovery took more than 16 hours with floating roller bags lifting the plane off the coral reef prior to bringing the plane back on shore.  The Navy estimates it will cost about $1.5 million to salvage the plane.  Divers inspected damage to the coral caused by the plane and oil boom anchors installed as a preventive measure to contain any oil leakage.  The seals on the plane were not compromised and the water quality did not indicate any fuel leakage.  Department of Land and Natural Resources divers will try to re-attach large coral heads broken off during the accident using epoxy.

Alaska Air has reached an agreement to buy Hawaiian Airlines for $1 billion in cash and by assuming $900 million in debt.  The combined airlines will have a market share of over 50% of Hawaii’s flights.  The transaction will provide Alaska Air a new hub in Honolulu and routes to Asia while Hawaiian customers will be able to fly to additional U.S. destinations.  Hawaiian will continue to operate under its Hawaiian brand.  Hawaiian Airlines has lost money in the past 14 of 15 quarters.

DLNR deployed its one millionth hatchery grown sea urchin in Kaneohe Bay to control two species of invasive seaweed that can suffocate coral reef patches in the bay.  Once a month, a team collects twenty-five of the mini “seaweed mowers” and induces them to spawn resulting in larvae 24 hours later. Researchers siphon the swimming larvae off the top and place them in larvae rearing tanks to protect the delicate animals during development. After 28 days, the team grows a biofilm on clear corrugated roofing material that the larvae attach to and start to look like little urchins called spat. Three weeks later, researchers move the spat to grow-out tanks when they are the size of a pencil eraser and then deployed to the bay once they reach the size of a dime.

The state Division of Aquatic Resources completed planting the last of six lab-grown coral modules in Hanama Bay to restore damage from a log scouring a boulder-sized brown lobe coral in 2020.  The Hawaii Coral Restoration Nursery pioneered a method of restoring Hawaiian corals by collecting coral fragments damaged by storms, quarantining them, and growing them in their lab.  The coral is cut in one-by-one centimeter pieces and the pieces are glued onto a concrete pyramid.  The coral grows along the edges and the pyramid is ready when the separate pieces touch.  The coral is then acclimated to the conditions where it will be planted.  The coral grows twenty-times quicker than coral in the wild and shows that damaged reefs can be restored.  The process takes about two years from collection to outplanting.

Halobacteria, a single-cell organism found in high salinity water, has likely colored the water at the Kealia Pond National Wildlife Refuge a bright pink color.  The U.S. Fish and Wildlife Service runs the wetland and bird sanctuary.  It has been monitoring the pink water since October 30th and is working with the Hawaii Division of Aquatic Resources on any action.  The University of Hawaii has been analyzing samples.  Coincidentally, Maui’s official color and the island’s official flower, the lokelani, are pink.

The University of Hawaii’s (UH) new Reserve Officer Training Corps (ROTC) program commissioned its first Ensign on the deck of the Battleship, USS Missouri in December. The newly commissioned officer will serve on the USS Shiloh, based in Pearl Harbor, after completing the three-month Basic Division Officer Course. Tim graduated from Tulane University back in 1989 on a ROTC scholarship and served on the USS Cavalla, a fast-attack submarine based out of Pearl Harbor.

Tim and Tracey attended the daughter’s, Ashley’s, wedding on November 18, 2024.  The delightful couple created a celebration fitting their personalities and interests to a tee.  They were grateful to have so many family members and friends attend the joyous event.

1031 Exchange Success Stories

 

Mililani to Maryland: The client hired Stott Property Management, LLC to manage a Mililani single-family home that they were renting out to a long-term tenant.  The house needed cosmetic repairs and the tenant was paying below market rent.  Stott Property Management, LLC successfully raised the rent in increments while keeping the tenant in place resulting in a 100% occupancy rate.

 

 Like many clients, they held onto the property to keep a piece of paradise that they could check on from time to time while generating modest cash flow.  As time progressed, they realized they were not traveling to Hawaii as much as they had in the past and then they reassessed their priorities in the pandemic.  Tracey spoke to them about investing the equity elsewhere and partnered them with Steve Ritchie of Railey Realty, Inc. in Maryland to find a suitable replacement property.  The condition of the Mililani house did provide some challenges, but Tracey was able put it on the market with a minimum of make-ready repairs.  Tracey successfully helped the clients sell the home despite several buyers backing out of the sale for various reasons.

 

Steve Ritchie then found them a beautiful home overlooking Deep Creek near Wisp Ski Resort to invest their equity and defer capital gains taxes.  The new property generated 2.8 times more revenue in 2020 than the Mililani property and the clients will be able to use the property for their family vacations as well.  Here is a photo of their beautiful Maryland vacation house courtesy of Railey Realty, Inc.

 

Mililani to Arizona and Florida: The client hired Stott Property Management, LLC to manage a Mililani townhouse that they were renting out to a long-term tenant.  The previous property management company managed thousands of accounts and experienced a lot of employee turnover.  The clients’ previous property manager resigned, the clients were not notified of the change, and their phone calls and emails were not returned.  The townhouse was in good shape and quickly rented once the interior received new paint.

 

The clients sold the Mililani townhouse and used the proceeds to buy a house in Jacksonville, FL and Tucson, AZ.  They decided to conduct the 1031 exchange for two reasons:

 

  • The combined rent was about 45% higher than what they received for the Mililani townhouse (50% higher when Hawaii General Excise Tax is factored in).
  • There is no capital gains tax in Florida and the capital gains rate is 4.5% in Arizona compared to 7.25% in Hawaii.

 

The clients plan on renting out the houses for at least three years.  They chose the locations because they are near military facilities and considered the rental markets to be ideal.

 

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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