October to December 2015 Newsletter

Oahu’s strong real estate market continues with median sales prices rising and the median sales price for condos setting a new record.  December’s single family home median sales price was $700,000 (1.4% higher than December 2014) and the condo median sales price was $386,250 (6.9% higher than December 2014).  The number of sales, number of pending sales, and number of new listings all increased compared to the previous year as both buyers and sellers appear to be motivated to do business.  Median sales prices should continue to rise as supply remains relatively constrained.  There is 2.6 months of remaining inventory for single family homes and 2.9 months of remaining inventory for condos.

Relief from high rents and home prices will continue to be an issue for the foreseeable future based on Governor David Ige’s response to recommendations from leading economists and developers who recommend removing the State Land Use Commission.  The commission was put into place in the 1950’s when Hawaii counties were not properly staffed to carry out the zoning responsibilities that most local governments in other states manage.  Today, the Land Use Commission duplicates many of the review functions carried out at the county level and provides a second venue for special interests to veto much-needed housing projects.  The Hawaii Supreme Court just ruled against an appeal made by the Sierra Club Hawaii Chapter and former state Senator Clayton Hee who argued that the Land Use Commission’s reclassification of land for D.R. Horton-Schuler Homes’ long-planned 11,750-home-master-planned Hoopili project in Ewa Beach violated the state constitution.  Unless something is done to streamline the zoning process and remove the unnecessary duplication at the state and county level, then chances are slim that developers can deliver the 66,000 homes economists forecast will be needed in the next ten years.

A Mixed Plate of Talk Story

Hawaiian Airlines will have a different competitor next year when Allegiant Air discontinues service to and from Honolulu in August 2016.  The carrier currently offers flights between Honolulu and Las Vegas and between Honolulu and Los Angeles.  Allegiant has decided to retire its Boeing 757 fleet rather than conduct scheduled maintenance due later next year.  While Allegiant Air is exiting the market, Virgin America, has entered the market and is expanding with the announcement of its second Hawaii route.  Virgin America completed its inaugural flight from San Francisco to Honolulu on November 2nd with CEO Sir Richard Branson onboard.  Travelers should enjoy Virgin America’s entry since the airline ranks near the top of customer satisfaction surveys.

The United States Supreme Court issued an injunction that halted the race-based Native Hawaiian-only election on behalf of five Hawaiian residents and one Texas resident of Hawaiian descent who opposed the election-process as discriminatory.  The purpose of the election was to select delegates to a planned constitutional convention that would lay the ground rules for a separate Native Hawaiian entity.

The budget for Honolulu’s rail transit project seems to get worse every month.  The projected cost of the project is currently $6.57 billion according to a report by KITV.  The $1.4 billion dollar cost over-run equates to a 27% increase over the original plan sold to taxpayers.  Drama and grandstanding continue at the City and County of Honolulu.  The Federal Transit Administration (FTA) is withholding its next $255 million in funding until the city council approves the five-year extension of the General Excise Tax (GET) surcharge.  Chairman, Ernest Martin, suggested foregoing the federal funding, sticking Oahu taxpayers with the full bill, and then making the rail transit system less useful by shortening the length of the project by one mile.  The city council is scheduled to vote on the GET extension in January, but Caldwell is urging the council to expedite the process.  HART is expected to spend more than $2.5 billion this fiscal year compared to an approved $1.8 billion budget.  HART says that the project can’t fund contracts for the next section of the rail route and may have to delay the schedule.

The 2015 Energy Resources Coordinator’s Annual Report highlighted Hawaii’s progress in creating electricity from renewable sources.  The state generated 21.1% of its electricity from renewable sources, far exceeding the original goal of 15% by the end of 2015.  Wind and rooftop solar voltaic systems generated over 56% of the state’s renewable electricity.  Despite having active volcanoes, Hawaii only generates 12.3 % of its renewable energy from geothermal and has only one new geothermal plant in the works out of a total of 60 new planned renewable energy projects.

Hawaii’s Public Utility Commission (PUC) ended the current net energy metering (NEM) program for new rooftop solar customers effective October 12, 2015.  The discontinued program allowed rooftop solar customers to receive credits equal to the full retail value of excess electricity supplied to the grid.  While Hawaiian Electric Company (HECO) claims that customers without rooftop solar paid a $38.5 million subsidy to rooftop solar customers, critics of the change counter that HECO benefited from receiving free electricity generation, lower utility fuel costs, and lower transmission costs because rooftop solar decreases the demand for centralized utility generation.  Starting October 21, new rooftop solar customers can apply for fast-track approval under a “self-supply” option or a standard review for the “grid-supply” option.  The self-supply option allows customers to receive the cost savings of using PV to meet their energy needs and allows a limited amount of excess electricity to be added to the grid for zero compensation.  The grid-supply option is intended to provide customers with the option of exporting excess energy to the grid in exchange for energy credits equal to a fixed rate of 15 cents to 18 cents per kilowatt-hour depending on the island that the customer lives on.  Customers operating under the old, discontinued, NEM agreement are not affected by this ruling.

Two of the solar leasing companies whose profitability depends on the solar tax credits and previous NEM program quickly filed suit against the PUC’s decision to modify the NEM program.  The new ruling makes these solar leasing arrangements much less profitable for leased systems because the companies will have to install more panels on homes to provide similar savings.  The leasing plans have recently become less attractive because HECO’s electric rates have dropped with the price of oil.  HECO currently charges about 25 cents per kilowatt-hour for electricity used in October.  Electricity rates were as high as 35 cents per kilowatt-hour last year before oil prices collapsed.

A statewide poll shows that a strong majority of Hawaii residents agree that there should be a way that science and Hawaiian culture can co-exist on Mauna Kea and support the construction of the Thirty Meter Telescope (TMT) project.  The poll shows that 44% of Native Hawaiians also support the project with 49% opposed to the project.  The poll also noted that most residents felt that failing to move forward with the project after all regulations were followed would hurt Hawaii’s already poor reputation as a place to do business.  The Hawaii Supreme Court ruled that the board acted improperly when it issued a permit prior to holding a contest case hearing.  TMT will have to go back to square one and repeat all the same steps before proceeding.  As if on cue, those protesting the new telescope declared that they will never accept the TMT project and will resort to illegal means if the project eventually gets approved.  The legal setback reminds many state voters of the Hawaii Supreme Court’s ruling that caused the Hawaii SuperFerry to cease operations and sell the state of the art ships to the U.S. Navy.  In that case, an overwhelming majority of residents also supported the SuperFerry.

The Hawaii Health Connector’s woes continue as executive director, Jeffrey Kissel, testified to the challenges associated with manually enrolling the 30,000 individuals that signed up for health insurance through the Hawaii Health Connector through the federal website, healthcare.gov.  Currently, the average enrollment time is roughly 1.5 hours for each individual and can take as much as four hours for non-English speaking customers.  Persistent problems with the healthcare.gov website and limited language resources require Hawaii Health Connector employees to sit with customers and coach them through the entire process.  State officials do not think that all Hawaii Health Connector customers will be enrolled by the January 31st deadline.  Jeffrey Kissel announced his resignation as executive director effective December for a new job in Washington, the Hawaii Health Connector laid off its entire staff on December 4th, and it transferred all functions to the state.

Pacific Business News summarized the disastrous implementation of Obamacare by the Hawaii Health Connector in a November article.  Of the 37,800 individuals that signed up for coverage under the new federal law, roughly 17,000 individuals signed up through the connector and only 8,802 had paid for the insurance.  The Connector spent $130 million of the $204 million in federal grants before the remaining $70 million was frozen when the Hawaii Health Connector failed to achieve financial independence.  The state of Hawaii effectively spent $14,769.37 to enroll each person in Obamacare via the Hawaii Health Connector.  Additionally, those insured individuals will have to dig deeper into their pockets to pay for health insurance as Kaiser received approval for a 34.4% rate hike in October.

Governor Dan Ige officially made homelessness a statewide emergency and about $1.3 million has been outlined to extend current outreach provider contracts through next July.  One of the needs that have not been adequately addressed is the lack of shelter space for families and children.  The governor’s announcement followed the final city and state sweep of the homeless encampment in Kakaako.  The Honolulu Star Advertiser documented another issue in a recent article describing how a man from Florida purchased a one-way ticket to Hawaii without having a job lined up or place to stay ahead of time.  The man ended up in a temporary shelter after running out of money.  The state is working on ways to discourage this type of behavior.

State officials plan to enforce park rules at Kakaako Waterfront Park and nearby Kewalo basin in mid-November.  Many of the homeless people that were removed by the city of Honolulu in October’s sweep of Kakaako, simply moved to these sites controlled and maintained by the state.  The state coordinator on homelessness will lead outreach efforts to those individuals living at the two sites and try to place them in shelters and with nonprofits that help the homeless find more permanent solutions.  The park areas are closed between the hours of 10:00 pm to 5:30 am.

630 acres of Oahu’s North Shore has been preserved in perpetuity according to a finalized agreement between the Turtle Bay Resort and the state of Hawaii.  Turtle Bay Resort will retain the development rights to build 725 more hotel units, about 20% of the original plan in return for the preserved site.  The coastline area, which represents about 4% of Oahu’s coastline, will be designated as a public park for recreational use.

A University of Hawaii data visualization project received $600,000 from the National Science Foundation for development.  The University of Hawaii will contribute an additional $257,000 for a system that will be the most modern in the United States when complete.  The project comes at a time when enrollment in information and computer science at UH is growing rapidly.  Approximately 950 researchers and students are in line to use the system for projects in oceanography, astrobiology, mathematics, computer science, electrical engineering, biomedical research, archeology, and computational media.  The computer system is scheduled to be operational within the next three years.

The University of Hawaii Rainbow Wahine volleyball team saw their fantastic season end a week before they would have liked.  UH fell to the University of Minnesota in four sets in the Elite Eight of the NCAA tournament a day after sweeping two-time defending champion Penn State.  The Rainbow Wahine finished the season with a 29 – 2 record.

Hawaii’s biodiversity is quite astounding considering its small footprint and relative isolation from the rest of the planet.  The number of known specimens recently grew with the discovery of 74 new beetle species of round-wasted predatory beetles found living on Haleakala volcano.  Currently there are 239 known species of beetles in Hawaii, all of which descended from a single common species.

A newly discovered fungus is killing hundreds of thousands of Ohia Lehua trees on the Big Island.  The disease, called rapid ohia death, was found to have affected 50% of the ohia trees across 6,000 acres of Big Island forest and is believed to have spread further.  Stopping the spread can be tricky because a tree can be infected months before showing any signs of the disease.  Ohia is important to Hawaii’s water supply because it is very effective at soaking rain-water into the ground and replenishing the water shed.  The tree’s nectar is a critical food source for many native birds and animals.

Odds & Ends

Domestic Violence in a Rental Property:  A recent law change allows victims of domestic violence to break a lease without penalty if the tenant or an immediate family member of the tenant has been a victim of domestic violence in the past 90 days.  The tenant shall give 14-days written notice to vacate and provide one of the following documents demonstrating domestic violence:

  • Copy of a valid order of protection issued by a court of any state;
  • Copy of a police report filed in any state; or
  • Copy of the conviction of a person.

The tenant must also provide a written statement describing that the tenant believes the person who committed the violence knows the address of the victim unless the person who committed the violence lives in the same rental unit.

If the tenant is one of multiple tenants, then the landlord can check to see if the other tenants can pay the rent.  If the remaining tenants are unable to afford the rent, the landlord can give the remaining tenants 14-days notice to vacate.  The security deposit is handled in the same manner as other check-outs unless the tenants instruct the landlord differently in writing.

Owner Rights Versus Responsibility:  A recent e-mail exchange got us to thinking of the delicate balancing act between a rental property owner’s expectations as a client of a property manager and their responsibility to their customer, the tenant.  The e-mail exchange started when an owner quickly scanned a paid plumbing invoice and incorrectly concluded that the plumber overcharged for a simple plumbing repair.  The owner then demanded three estimates for all repairs (simple or otherwise) before authorizing any repair work to be done.

If the landlord was the only customer in this scenario, then this type of reasoning makes sense.  However, when a rental property is concerned, the ultimate customer turns out to be the tenant, not the owner.  In most leases, the tenant must cooperate with the landlord to get necessary repairs completed and this often includes taking time out of their work day.  Since the tenant pays rent in return for a safe, functioning property, the tenant has the right to expect that the landlord will address any functional deficiencies in a quick and efficient manner.  Requiring three estimates before approving a simple repair would require the tenant to meet three contractors, most likely at three different times to obtain estimates, and then a fourth time for the chosen contractor to complete the repair.  We are not aware of many tenants that would tolerate this process for a simple repair.

A good property manager helps maintain the delicate balance between controlling costs and providing customer satisfaction in the following ways.

  • Develop a network of reliable, cost competitive contractors to quickly address routine maintenance and repair items.
  • Develop repair policies that balance controlling costs while addressing required repairs as quickly and efficiently as possible.
  • Put a system in place to track all repairs until completed.
  • Provide monthly statements that include paid invoices.

At the end of the day, Stott Property Management properly managed the repairs in question.  The three plumbing deficiencies were quickly addressed and the owner concluded that he did not get ripped off.

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 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. However, 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 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; i.e., prior to 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’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 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; however, on the 46th day, you are locked-in to whatever has been identified as 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 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 andexclude 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 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 $300,000 x 2/23 or $26,087. The remaining $273,913 exceeds the $250,000 limit for single Mary, so Mary ends up with $50,000 taxable ($26,087 + $23,913) 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 primary residence even with ownership now a required five years.  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. Contact us toll-free (1-800-922-6811), locally (808-254-1515) or via e-mail (home@stott.com).  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.