April – June 2010 Quarterly Newsletter

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In late-June, mortgage rates fell to an average of 4.69%, the lowest rate since the 1950’s making this an ideal time to purchase a new home. It is also a time to examine if it is cost-effective for readers to refinance their mortgage(s). The old thumb-rule of needing a reduction of at least two percentage points does not work well at our low mortgage rates. Using a reduction of 1% and a mortgage balance of $400,000, I’ll compare 5.69% to 4.69%. For an amortizing calculator, click here. At 5.69%, the principal and interest payment on $400,000 would be $2,319/mo. At 4.69%, or one percentage point lower, the principal and interest would be $2,072/mo for a difference or savings of $247/mo or almost $3,000/yr. If we assume the cost of refinancing is 2 points or $8,000, then it would probably be beneficial for you to refinance your mortgage providing you plan to own the home for at least three more years. A more extensive analysis is complicated and usually not necessary. Merely comparing the two mortgages is often sufficient to enable a decision as to whether refinancing is practical.

The deadline for closing on home purchases under the First-Time Homebuyer Credit was extended from June 30th to Sept 30th. Many of the buyers purchased short-sale properties that typically take 3-4 months to close, so this extension provides those buyers an additional three months to close. We should see some improvement in sales resulting from the extension and the lower mortgage rates. Here is a link in the July 8th Honolulu Star Advertiser titled: Home prices up slightly.

Every couple of years, I orient the newsletter towards 1031 exchanges, which has been done with this one. Note that there have been some relatively recent exchanges for exchangers that plan to occupy as a principal residence, home that they acquired via a 1031 exchange.

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 that could significantly impact upon a 1031 exchange. I 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.

Note: We have participated in a large number of 1031 exchanges and usually have several such transactions in escrow at any given time. However, we are not licensed to provide either legal or tax advice. Licensed professionals such as attorneys or CPA’s should be consulted for such advice. This comment applies to the entire newsletter.

Note: This paper will use the terms “old property” for the property being sold and “new property” for the property being purchased. A property may consist of more than one piece of real estate.

Background: Section 1031 of the Internal Revenue Code (IRC) provides for the deferment of long-term capital gains taxes on the sale of investment real estate when it is exchanged for other investment real estate of equal or greater value than the real estate being sold. A common misconception is you will have to find someone to trade properties with you. Most 1031 exchanges involve two entirely separate transactions. In one transaction, you sell your old property and in the other, you purchase your new property. There is normally no reason for the buyer of your old property and the seller of the new property to have any contact with each other. Often, the properties are located in two different states; e.g., most of our exchanges involve property in Hawaii being exchanged for property on the Mainland.

Qualified Intermediary (QI): The IRS mandates that you use a completely independent third party to supervise the exchange. Because this third party must be completely independent, it cannot be your real estate agent, accountant or attorney. The independent third party is usually referred to either as an intermediary or as qualified intermediary (QI); however, in some areas of the country the third party may be called either a facilitator or an accommodator. This paper will use the term “QI.” The QI can be located anywhere in the country; they do not need to be located near you or near either of the properties involved in the exchange.

The following steps have been changed; however, they help explain the role of the QI. The QI takes title to the old property for a brief instant in the process of having it sold from you to the buyer; i.e., title passes from you through the QI to the buyer. Similarly, the QI takes title to the new property for a brief instant in the process of having it sold from the seller to you. Therefore, the QI has owned both the old and the new properties and can exchange one for the other. Today, the QI no longer has to hold title to both properties. In 1991, the real estate industry successfully lobbied Congress to have the law changed, as escrow companies were charging double escrow fees; i.e. seller to QI and then QI to you. Today, in lieu of taking title to both properties, the QI is tasked to provide instructions so that both transactions are closed in a manner that conforms to Section 1031 of the IRC.

Properties & Timing: Both the old property and the new property must be investment real estate; in most cases they are rental properties. The two properties do not need to be the similar; e.g., you could exchange a house in Hawaii for two or more Mainland condos and vice versa. Almost any type of real estate qualifies such as a house, condo, store, office or even vacant land. However, your personal residence or a second home does not qualify. But, you could rent the new property first so that it qualifies as investment property and then occupy it yourself. Many of our clients do this; i.e., they use the equity in their Oahu property to assist them in purchasing a future Mainland residence. The new property must be rented for at least a year prior to being occupied in order for it to qualify as investment real estate.

With some very few exceptions, all of the exchanges made by our clients have been deferred exchanges where the old property is sold prior to purchasing the new property. It is possible to do this in reverse order and purchase the new property first. 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 have involved absentee owners conducting their first 1031 exchange.

When the old property closes, the proceeds from the sale go to the QI who banks the funds until you’re ready to purchase the new property. To defer all your capital gains taxes, you must buy new property that is equal to or higher in value than the old property. You must also reinvest all the cash proceeds from the sale into the purchase of the new property. The QI maintains the funds from the sale of the disposable property and then makes those funds available in order to enable the purchase of the new property. You cannot have access to any of the proceeds from the sale 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; however, on the 46th day, you are locked-in to whatever has been identified as the new property.

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; however, it would still have to be closed within the 180-day-period. Most exchangers identify more than one new property.

Deferring Taxes: A 1031 exchange enables an owner to be able to defer both the federal and state capital gains taxes that they have on the sale of their old property and roll those taxes over into the new property. Note that the taxes are deferred, not excluded. The current federal capital gains tax rate for most exchangers is 15% on all component of gain except depreciation recapture, which is taxed at 25%. The state 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%). It is unknown what the federal capital gains tax rate will be in 2011 and beyond. Without any action in Washington to change the existing law, the rate will automatically revert back to 20% in 2011. However, action to raise taxes is expected, therefore, the rate is likely to be higher than 20%.

Recent Rules: Three relatively recent rules apply to principal residences. The Tax Relief Act of 1997 enabled a homeowner to sell their principal residence and exclude up to $500,000 of gain (married) or up to $250,000 (single) providing they had occupied the home for an aggregate 24 out of the prior 60 months. So an owner only needed to own the property for three years, one year as a rental to qualify for the exchange and then two years as a principal residence to qualify for the Tax Relief Act of 1997. In October 2004, there was a change to the 1997 law. An owner who acquired their principal residence by way of a 1031 exchange must now own the property for at least five years before they sell it in order to be eligible for the exclusion. The owner still needs to rent it for one or more years so it qualifies for the exchange and then have it be their principal residence for at least two years. The exchanger also has to pay depreciation recapture on depreciation claimed (after May 6, 1997) while the property was a rental; i.e., depreciation recapture while the property was a rental will not be excluded.

The Housing and Economic Act of 2008 reduces the capital gains that can be excluded when a homeowner sells a principal residence that they acquired via a 1031 exchange, 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 will be the numerator or top of a fraction with the bottom or denominator (think down) 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 1/1/13, 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. Two years later on 1/1/13 Mary will have owned it for a total of 20 years. Therefore, the fraction for non-resident use is 2/20. Or, the taxable gain is $300,000 x 1/10 or $30,000. The remaining $270,000 exceeds the $250,000 limit for single Mary, so Mary ends up with $50,000 taxable ($30,000 + $20,000) and $250,000 that is excluded. Mary would also owe depreciation recapture after May 6, 1997.

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 principal residence even with ownership now a required five years.  This is still a very viable investment tool, particularly for property bought prior to 1/1/09. Converting property into a principal residence is discussed later in the newsletter. On the following page is a paper prepared by a Mainland QI company that discusses non-tax reasons to conduct a 1031 exchange.

Some Final Thoughts: A 1031 exchange is not the right investment tool for everyone. Over the years, we have assisted many owners in making a decision not to conduct an exchange. Often, all that was required was for us to estimate the owner’s capital gains taxes. Contact me toll-free (1-800-922-6811), locally (808-254-1515) or via e-mail (team@stott.com) and I’ll discuss this with you. The following items will make our conversation more meaningful: (1) read my 1031 paper first, as it should answer many questions and often triggers some new ones; (2) note the figure on line 20 (Depreciation Expense) of the Schedule E (Supplemental Income and Loss) to your last 1040 federal tax return. I can estimate your taxes much more accurately if I know how you have been depreciating your property.

A Mixed Plate of Talk Story

Honolulu City Councilman, Republican Charles Djou, pierced the Democrats’ hold on the state’s congressional delegation in a May winner-take-all special election for Congress by becoming the first Republican in 20 years to represent Hawaii in Washington. Djou took advantage of a bitter split between the two major Democratic candidates, Senate President Colleen Hanabusa and former congressman Ed Case, to win the seat vacated by Neil Abercrombie, who is concentrating on a gubernatorial race against Honolulu mayor Mufi Hannemann. Djou finished with 39.4% of the votes while Hanabusa had 30.8% and Case 27.6%. It was expected there would be a hot Democratic primary involving Case and Hanabusa; however, Case bowed out thereby giving Hanabusa a virtual free ride. Lots of rumors circulating as to why Case took such a step; perhaps a combination of all of the following: A Democratic win in November versus Djou is no sure bet even with the large Democratic majority; Case is in debt from the special election and might have difficulty raising funds for a primary race against Hanabusa who beat him in both votes and funds raised; Case earned IOU’s for a future political race from the established Democrats and labor unions that supported Hanabusa.

NCAA rules allow a college to play 12 football games each year exclusive of postseason bowl games. To offset the cost of traveling to Hawaii, a 13th game is allowed if the school is playing a game in Hawaii. This rule, enacted in 1955, has come to be known as the “Hawaii Exemption.” In 2002 and 2003, the NCAA for various rule violations hit Alabama with a probation against appearing in any post season bowl games. Alabama then scheduled games against Hawaii and hyped those games for recruiting purposes as bowl games. The NCAA rules subsequently were changed to include exempted games as well as post season bowl games. USC has recently been hit with a two-year probation similar to the one involving Alabama. The USC game versus UH was scheduled in 2001, before there were any allegations of wrong doing by USC and before the rules were changed to include exempted games. A game with USC sells out Aloha Stadium plus this one is being held on a Thursday night to enable a season opening game on national TV.  If the game were to be cancelled, UH would lose over a million dollars according to the UH Athletic Director. The million-dollar question for UH for several months has been: Will there be a USC football game this September? . . .  late-June answer . . . YES!!!

The April 23rd issue of the Wall Street Journal had a front-page article concerning the practice in Hawaii of politicians standing on street corners along with their campaign supporters waving signs at passing cars. Everyone does it, even including Senator Daniel Inouye who has represented Hawaii in the Senate for 45 years and now runs essentially unopposed . . . The Hawaii Pacific University (HPU) Cheer and Dance teams repeated as Division II National Champions at Daytona Beach, FL in early April. The HPU Large Coed Cheer Team won for the 8th consecutive year while the HPU Dance Team won for the 5th consecutive year. The Dance Team also placed first in the Hip Hop category, a competition category offered for the first time this year. A number of HPU students placed in the top three for individual or small group competition. 5,000 student athletes and 15,000 spectators convened in Daytona Beach making the competition the largest college cheer and dance championships in the world . . . Two new primetime TV shows are scheduled for Hawaii. CBS will do a remake of “Hawaii Five-O” while ABC just announced they would have another medical-oriented show called “Off the Map” from the same creative team behind “Grey’s Anatomy” and “Private Practice.” In “Off the Map,” Hawaii will double for the Amazon. ABC’s decision comes less than a month after the final series of their hugely successful “Lost,” which filmed exclusively in Hawaii for six seasons.

Rent for retail space on Waikiki’s Kalakaua Ave was down nearly 17% in May compared to a year ago, however, it still ranked as the 5th most expensive retail space in the country at an annual rent of  $300 per square-foot according to the results of a survey released in mid-June by Collier’s International. The top five were: New York’s Fifth Ave ($1,250), New York’s Madison Ave ($590), Beverly Hill’s Rodeo Drive ($423), San Francisco’s Union Square ($400), and Kalakaua Ave . . . As expected; a buyer was unable to be located for the Honolulu Star Bulletin. Offers were received from three groups but they all fell short of the paper’s estimated liquidation value. As a result, the two daily newspapers have now consolidated into the Honolulu Star-Advertiser . . . Carnival Cruise Lines will introduce two round trip cruises from California to Hawaii in 2011 and 2012. The voyages will leave on Dec. 2, 2011 from Los Angeles and April 13, 2012 from San Diego. The 15-day sailings will include daylong stops at all five major Hawaii ports: Honolulu, Kahului on Maui, Nawilwili on Kauai and on the Big Island, Hilo and Kailua-Kona.

Here is a link to a June 9th newspaper article that discusses the large tent cities of homeless people on Oahu. Various shelters exist; however, efforts to handle this problem are very frustrating, as most of the homeless would prefer to live in tents rather than moving to shelters where they would be required to conform to various rules and regulations. The police do a reasonable job of keeping the homeless off of the major beaches and city parks where they would directly impact upon the tourist trade. However, often it is merely a matter of shuffling the homeless from one spot to another . . . Getting a lot of negative publicity these days is shark finning. The practice involves cutting the fins off of sharks and then discarding the live animals in the ocean to drown. The shark fins are the key ingredients in shark fin soup, a Chinese delicacy that tastes like a weak chicken consume. The fins are not eaten, but thrown away like chicken bones. The cost for a bowl of soup ranges from $15-$20 in Hawaii to up to $1,000 in Hong Kong for a fancy, expensive affair. Currently about 175 countries have signed an environmental treaty to halt this practice. The Hawaii ban takes effect July 1, 2011 and includes heavy fines for anyone caught selling the soup in the state: $5,000 for first offense, $50,000 for a second offense and up to a year in jail for a third . . . Disney’s Aulani resort in Ko Olina will start taking reservations and time-share inquiries on Aug. 2, 2010, a year before it is set to open on Aug. 29, 2011. The first Disney hotel not near a theme park will have 360 hotel rooms and 481 two-bedroom Disney Vacation Club villas along with a large conference center, two restaurants, a huge spa, swimming pools, a snorkeling lagoon, etc.

Furloughs for about 10,000 city employees will begin in July, closing most city offices for two days each month . . . In the latter part of 2009 a state tax auditor assumed that a Gulfport, Mississippi rental property I own was located in Hawaii and that I had failed to pay General Excise Tax (GET) for several years. Without verifying her assumption, the auditor generated several pages of computer detail as to the taxes I owed consisting of all the back GET plus a 50% penalty plus interest at 8% . . . GET is not required for rental properties not located in Hawaii. Copies of my Federal Schedule E’s easily resolved my problem. My experience made me believe, though, that Hawaii may be examining new auditing areas. We didn’t see any indication of this until a couple of months ago when we started getting Notices of Non-Filed GET Tax Returns on almost a daily basis including five in one day. Fortunately, none of our clients have had to pay any back taxes. That may be the reason that it has now been about two months since we got our last Notice . . . Contrary to what you may have heard about short sales not applying to investors, we have been successful in getting several absentee owners (investors) approved for short sales in Hawaii. Approval is far more likely if we can start the process early on, preferably before you start missing any mortgage payments. If you can document that you will be unable to continue making mortgage payments 3-4 months in the future, we should start the short sale process now.

For additional information concerning short sales, contact my daughter, Tracey Stott Kelley, locally at 808-254-1515, toll-free at 1-800-922-6811 or by e-mail at tracey@stott.com

Mahalo nui loa for the nice comments concerning property management that were in my last newsletter. For additional information concerning property management contact my son-in-law, Tim Kelley, locally at 808-254-1515, toll-free at 1-800-922-6811 or by e-mail at tim@stott.com

Odds & Ends

Refinancing Your Mortgage: In late-June, mortgage rates fell to an average of 4.69%, the lowest rate since the 1950’s. For many owners, the low rates make this an ideal time to examine if it is cost-effective to refinance their mortgage. The old thumb-rule of needing a reduction of at least two percentage points to make refinancing cost effective does not work well with our very low mortgage rates. For example, I’ll compare a reduction of only one percent or 5.69% to 4.69% using a mortgage balance of $400,000. For an amortizing calculator, click here. At 5.69%, the principal and interest payment on $400,000 would be $2,319/mo. At 4.69% or one percent lower, the principal and interest payment would be $2,072/mo for a savings of $247/mo or almost $3,000/yr. So, if you expect to own the home for three or more years, it would probably be beneficial for you to refinance providing the cost of the refinancing is less than $9,000. The cost of refinancing is available from your lender. A more comprehensive analysis is complicated and may not be necessary. Merely comparing the two mortgages is often sufficient to enable a decision as to whether refinancing is practical.

Converting a Second Home Into a Principal Residence: This can be a very useful investment tool to an investor that wants to pull cash out of their real estate without having to pay sizable taxes. There are a number of factors that are used to establish a principal residence such as:  (1) the length of occupancy; (2) the location of employment; (3) the principal place of abode for family members; (4) the address used on the taxpayer’s federal and state tax returns; (5) the address where the taxpayer is registered to vote; (6) the location of the taxpayer’s bank(s); (7) the address used for automobile and driver’s license registrations; and (8), the location of the taxpayer’s religious organizations and recreational clubs. It is important to keep in mind, though, that you can only have one principal residence at any given time.

Assume you own property in Hawaii (HI property) with considerable equity and property in California (CA property) that is your principal residence. You sell the HI property via a 1031 exchange and replace it on the Mainland with (new property) that will be adequate to you as a residence for four years. You rent the new property for one year so that it qualifies for a 1031 exchange and then occupy it as your principal residence for four years to meet both the five years of ownership and the two out of five years exclusion requirement. Then you sell the new property and take the exclusion. If it is rented for one year and occupied for four years, the amount of gain being taxed, for your non-resident use would be 1/5 or 20%; i.e., only 20% of the gain would be taxable. You can only do this once every two years, so before you start, you should plan what you want to do with the CA property. You might want to sell it early on and take the exclusion. This would enable you to exclude gain from the CA property and the sale of the HI property as well as any gain from the sale of the new property.

Many readers of the newsletter alternate between living on the Mainland and in Hawaii with most of them claiming their Mainland home as a principal residence and their Hawaii home as a second home. Some of them may find it beneficial to shift their principal residence to Hawaii in order to claim the two out five-year exclusion. You have to occupy a principal residence for two out of the past five years to qualify for the exclusion; however, the months of occupancy do not need to be continuous. Moreover, you don’t need to actually have lived in it for two full years; e.g., an owner that now alternates between living in Hawaii and on the Mainland with their principal residence being their Mainland home, doesn’t change their principal residence each time they live for part of the year in Hawaii. Assume you own a HI property and a primary residence in CA. You start the process by shifting your primary residence to the HI property. However, the day you make that change is also the day that you can no longer claim the CA property as your primary residence. So you may also want to sell the CA property early on and take the exclusions.