October to December 2016 Quarterly Newsletter

The median sales price on Oahu continues to climb as strong demand continues in a market with constrained supply.  The median sales price in December for single family homes was $730,000 (4.3% higher than December 2015) and for condos was $390,000 (1.0% higher than December 2015).  December demand was particularly strong as single family home sales surged 15.4% and condo sales soared 23.5% higher than December 2015.  Sales should remain higher in the next few months and pending sales for houses is 15.4% higher and for condos is 20.2% higher than last year.  The supply of homes continues to drop as new listings can’t keep up with the current pace of sales.  There is currently 2.5 months of remaining inventory for single family homes and 2.6 months of remaining inventory for condos.

The University of Hawaii Research Organization (UHERO) predicted in September that housing prices would continue to climb as job growth and rising income provide potential buyers more purchasing power while housing supply remains constrained.

While the sales market is soaring, the long-term rental market has turned and rents have been dropping for the last quarter as a sudden surge of available rental properties has flooded the market.  Stott Property Management had more vacant rental properties in December than the last time the rental market turned.  Tim Kelley, who regularly updates his clients, has never seen so many Oahu vacancies advertised for rent in December.  A large number of military tenants have received orders to leave the island over the past few months and it appears that military home owners who have purchased a home over the past few years have decided to try and rent their homes versus selling when they received orders.  Honolulu has seen a net migration out of the city as high rents have convinced many people to move and seek their fortunes elsewhere.  Tim and Tracey saw a similar sales and rental market in 2006.

A Mixed Plate of Talk Story

December 7th marked the 75th anniversary of Japan’s attack on Pearl Harbor.  The 75th commemoration of the attacks on Pearl Harbor includes events and memorials dedicated to the USS Utah, USS Oklahoma, and USS Arizona.  Both local and national newspapers have been documenting the heroics of those that died and survived on December 7, 1941 and of those 90 plus year old men and women that returned to take part in the numerous events honoring and remembering those heroes.  Tim and Tracey sat down at Wailuna Coffee Shop in Waikiki with the son-in-law of a Pearl Harbor survivor on Friday, December 2nd.  He shared that he had to drive his father-in-law home the previous evening when strangers kept buying scotch to thank him for his service.  His father-in-law served on the USS Tennessee and woke up in a hospital bed after a torpedo struck the battleship and blew him into Pearl Harbor.

 

Hawaii Volcanoes National Park opened a new lava viewing area following the collapse of a large lava viewing area into the ocean on New Year’s Eve.  Park Rangers had to chase after five visitors and force them to turn around 15 minutes before the area that the visitors were standing on collapsed into the ocean.  Nearly 26 acres of a lava delta are now gone in addition to more than four acres from an older coastal cliff area.  The new viewing area is approximately 900 feet east of the current lava flow.  The New Year’s Eve collapse lasted several hours creating blasts of volcanic rock, waves, and plumes of debris and gas.

 

The 9th U.S. Circuit Court of Appeals ruled that three Hawaii counties may not regulate genetically modified crops or pesticides.  As a result, Maui’s ordinance banning genetically engineered farming, Kauai’s notification requirements for pesticide use, and Hawaii County’s prohibition of open-air testing for genetically modified crops will not go into effect.  The decision was a victory for seed companies Monsanto and Syngenta.

Thirty Meter Telescope (TMT) officials have chosen Spain’s Canary Islands as an alternative site for the $1.4 billion observatory.  TMT would still prefer to build on the summit of Mauna Kea but will move if the permitting process doesn’t get started soon.  In December 2015, the Hawaii Supreme Court ruled that TMT’s conservation district permit was improperly awarded eight years after the permitting process began.  TMT has reported that it has invested $170 million for construction and manufacturing.  When completed, the observatory will house the most advanced and powerful optical telescope on the planet with a 30-meter diameter primary mirror.

Local election results in Hawaii show that the state continues to be dominated by one party rule.  When Stanley Chang defeated incumbent Sam Sloan, a Republican, Hawaii became the only state in the nation with an entirely Democratic state Senate.  Mayor Kirk Caldwell fended off challenger Charles Djou, and Brian Schatz, Colleen Hanabusa, and Tulsi Gabbard (all Democrats) cruised to victory.  The domination of the Democrats in Hawaii runs counter to Republican gains in the rest of the country where Republicans have gained steadily since 2008.  There are currently 33 Republican governors, Republican majorities control 69 of the 99 state legislatures, Republicans control both the House of Representatives and the Senate, and Donald Trump was elected President.

David Ige pledged in his January 2016 State of the State speech to cool 1,000 classrooms by then end of the year and was subsequently funded by the state legislation to the tune of $100 million.  On November 15th, the Department of Education (DOE) had reported that they finished cooling 42 classrooms statewide.  General contractors involved with the process have complained that the overly complicated project specifications caused significant delays and resulted in initial bids coming in significantly over budget.  The DOE now projects that 1,000 classrooms should have air conditioning by the end of 2017.

Kakaako’s building boomlet has prompted the City and County of Honolulu to renovate and upgrade Ala Moana Regional Park across from the Ala Moana Shopping Center.  Renovations and improvements include new sand volleyball courts, renovating bathrooms, repairing the Magic Island exercise path, irrigating the great lawn, fixing rocky beach areas, building a new playground, and hiring staff to maintain the park and improve safety.  Good luck finding parking.  The park is already one of the most heavily used parks in Honolulu.

Hawaii currently is ranked #48 in a category that makes many people’s skin crawl.  According to Orkin, Honolulu ranked #48 among cities with the most bed bugs.  Orkin’s bed bug revenue rose more than 10% compared to last year.  Bed bugs were virtually unheard of in the United States ten years ago.

The Honolulu Police Department (HPD) earned some recognition for quickly responding to criticism from neighborhood boards and to an article by the Honolulu Star-Advertiser for failing to list violent crimes on its crime data map.  The Honolulu Star-Advertiser first ran the article in October noting that the Honolulu Police Department (HPD) does not include violent crimes on their crime mapping site.  HPD’s website is the only site among more than 150 police websites that the newspaper investigated that excludes violent crimes.  In November, HPD added ten new categories to the site including arson, assault, drug / alcohol violations, homicide, and robberies.  The welcomed change now puts HPD’s crime mapping site on par with other departments around the country.

Honolulu’s police chief, Louis Kealoha, has decided to retire from the Honolulu Police Department (HPD) as he focuses on defending himself in a federal grand jury investigation into alleged conspiracy and corruption that centers around Louis Keoloha, his wife, Katherine Kealoha, Deputy Prosecutor, and several police officers.  Louis Keoloha sworn in as police chief in November 2009 amongst enthusiast support from the police union, State of Hawaii Organization of Police Officers (SHOPO) and police officers.  A large contingent of police officers was present to congratulate Kealoha after he was sworn in at the mayor’s office.  Unfortunately, Keoloha’s years as police chief have not lived up to the high hopes of his supporters.  His term has been marked by a long string of news stories about illegal activity, abuse of power, spousal abuse, and other infractions by Honolulu police officers.  In late 2014, Keoloha and his wife became involved in a messy family dispute with Katherine’s uncle, Gerard Puana.  The dispute spilled over in court when the Kealoha’s accused Puana of stealing their mailbox.  Puana’s public defender accused the police chief of intentionally causing a mistrial when he testified as a witness on the stand.  The public defender turned over FBI documents suggesting further wrong doing by the department, which has apparently resulted in the grand jury investigation.  No decision has been made regarding Kealoha’s retirement or separation package.  Kealoha’s second term was expected to run through November 27, 2019.

Hawaiian Electric Company, HECO, announced its new time-of-use rates for Oahu.  The current rate is 24.1 cents per kilowatt-hour (kwh).  The first 5,000 customers that sign up for the following plan will be charged the following rates under time of use.  Customers will pay 14.9 cents per kwh for usage between 9:00 am to 5:00 pm, 37.3 cents per kwh between 5:00 pm and 10:00pm, and 23.7 cents per kwh between 10:00 pm and 5:00 am.  The rates are indicative of the large penetration of roof-top photovoltaic systems (PV) on Oahu’s grid.  Prior to PV, the higher demand for electricity would result in higher prices during the day and lower prices in the evening as air conditioners consumed less energy.  Some electrical grid experts argue that time-of-use billing is necessary to more fully integrate renewable energy and encourage consumers to adjust their electrical demand to match available supply.

Customers wanting to install new roof-top photovoltaic systems (PV) currently have only one option available.  Oahu reached the arbitrary grid-supply cap back in October and new systems must be self-supply.  In other words, the new systems must come with battery systems to store any excess electricity generated during the day for night use.  Hawaiian Electric Company (HECO) has received 322 applications as of mid-November and approved about 100 of those applications.

The Kauai Island Utility Cooperative (KIUC) has been able to lower electricity rates by 18% since 2008 by integrating renewable energy into its grid and decreasing the amount of diesel fuel used.  KIUC stated that renewable energy now accounts for roughly 36 percent of the island’s electricity supply and includes large scale solar systems and a new 7-megawatt biomass plant.  On some sunny days this year, KIUC was able to generate 97 percent of the electricity used from renewable sources (77 percent from solar).  Now, on an average clear day, KIUC can shut down all but one of its diesel generators.

Hawaiian Electric Company (HECO), on the other hand, is seeking a 7% increase to its base rate.  It appears that the state sponsored monopoly’s margins continue to be squeezed by homeowner’s adoption of rooftop solar.  Rate increases during historically low oil prices help those argue that the cooperative model is superior to the regulated monopoly model.  The difference in Kauai’s results and Oahu’s results appear to support the cooperative model.

As if on cue, the Hawaii Island Energy Cooperative (HIEC) was recently granted tax exempt nonprofit status by the Internal Revenue Service, a major step in becoming an operating non profit utility similar to KIUC.  HIEC’s electricity plan includes new solar, wind, and energy storage to reach the states 100% renewable energy goal.  Notably absent was geothermal energy.  The Big Island is the only island utilizing geothermal energy and could supply the entire island with clean, renewable energy.  Hawaiian Electric Light Company (HELCO), a subsidiary of HECO,  did not comment on HIEC move to purchase and take over management of HELCO’s assets.

Ko Olina is cementing its position as a luxury resort destination on Oahu with the announcement of Atlantis Resort & Residences on Oahu.  The developer has released plans to develop 800 hotel rooms, 524 luxury residences, an aquarium, water park, restaurants, bars, a spa, gym, wedding chapel, and conference facilities.  Atlantis Resort & Residences will join Four Seasons Hotels & Resorts, Disney’s Aulani Resort & Spa, and Marriott Ko Olina.

 

Alexander and Baldwin Inc.’s Hawaiian Commercial & Sugar Co. harvested its last crop of sugar cane in December.  Both the sugar processing plant and the power plant were mothballed on December 23rd.  The remainder of the approximately 700 employees was laid off on December 30th.  Cheaper sugar production elsewhere in the world led to the demise of Hawaii’s once booming sugar industry.  Alexander and Baldwin Inc. plans on dividing up the plantation into smaller farms with a variety of agricultural projects.

Andy Mohan Inc., a men’s clothing store specializing in custom tailored suits, is closing its downtown store after nearly 50 years in business.  Founder Andy Mohan died in 2013 and Alies Mohan who owned the store with Andy is retiring.  Tim Kelley was fitted for his first business suit at Andy Mohan back in 1995 when he was resigning his commission from the U.S. Navy and preparing for business interviews.  He remembers getting fitted  personally by Andy.  Business attire on Oahu has changed significantly over the past 50 years as most Hawaii business professionals have shed the business suit in favor of slacks and aloha shirts.  Tim is also grateful for the change in business fashion even though he is saddened by the closure of an iconic business.

Odds & Ends

Note:  Stott Real Estate, Inc. is not licensed to provide tax or legal advice.  The following article is for information only and Stott Real Estate, Inc. recommends that you speak with a licensed tax advisor and/or an estate planning attorney before making any decisions.

Avoiding Probate in Hawaii:  The state of Hawaii requires probate when an individual dies and has more than $100,000 in assets or owns real estate in Hawaii.  In general, probate will be required in every state where the decedent owns real estate.  Probate is typically a costly and time consuming process in Hawaii.  The minimum time to complete probate is typically six months and it can take as long as nine to eighteen months depending on the complexity.  As a result, individuals who own real estate or have more than $100,000 in assets should consider steps to avoid probate if possible.

One method to avoid probate became possible in 2011 when the state legislature passed and the governor signed the Uniform Real Property Transfers on Death Act.  The intent of the law is to allow for a property to transfer to a designated individual upon the time of death by the current owner by recording a deed called a “Transfer on Death Deed.”  While recording a Transfer on Death Deed helps to avoid the time and cost of probate, estate planning attorneys recommend against this option for the following reasons:

  1. Although the transfer on death deed can be revoked, it requires the revocation to be signed, notarized, and recorded in the same manner as the original transfer on death deed.
  2. Although the statute provides that the beneficiary receives the property to existing encumbrances, most lending institutions will not lend on a property subject to a transfer on death deed. As a result, an individual would have difficulty refinancing an existing mortgage or obtaining a new loan against the property.
  3. If an individual becomes disabled or incapacitated, the property is in “limbo” because no one has authority to sell the property or obtain a reverse mortgage to pay for health care needs.
  4. There are issues if the beneficiary of the transfer on death deed dies before the property owner.

One interesting note regarding transfer on death deed.  The beneficiary is divested of the right upon divorce from the transferor or conviction of a homicide of the transferor.

Therefore, estate planning attorneys still favor setting up a revocable trust.  Assets, including real estate, avoid probate if they are held in a revocable trust.  The only downside to a revocable trust is the high initial cost to create the trust and transfer property into the trust.  However, this cost is usually less than the cost of probate and much easier on an executor of the will.  The revocable living trust has two advantages:

  1. The avoidance of Probate Court costs and associated delays.
  2. Management of living-trust assets if the trustor becomes incapacitated.

When a revocable trust is created, the trustor is the individual who is placing his or her assets in the revocable living trust.  The trustor names a successor trustee to manage the trust when he or she dies or becomes incapacitated, and the beneficiaries of the trust.  The beneficiaries of the trust receive the assets from the trustee when the trustor dies without Probate Courts interference.

 

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.

 

  1. 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.

 

  1. 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 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 held as an investment property for a period of time as the amount of the tax exclusion will be adjusted by the non-resident use of the property. This law became effective 1/1/09. The amount of time of non-resident use after 1/1/09 is the numerator or top of a fraction with the bottom or denominator of the fraction being the total time since property acquisition. That fraction times total gain (exclusive of depreciation recapture after May 6, 1997) is the gain that will be taxed to the homeowner.

 

Example:  Single Mary bought her Oahu home on 1/1/93 for $200,000 and rents it for 18 years until 1/1/11 when she occupies it as her principal residence. Two years later, on 1/1/16, Mary sells the property for $500,000 and has $300,000 of gain.

 

The non-residence use of the property by Mary prior to 1/1/09 does not apply to the new law. Therefore, Mary has only two years of non-residence use (1/1/09 to 1/1/11) when she then occupies it as her principal residence. Five years later on 1/1/16 Mary will have owned it for a total of 23 years. Therefore, the fraction for non-resident use is 2/23. Or, the taxable gain is $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.

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