October to December 2017 Quarterly Newsletter

The Oahu median sales price continues to climb as supply constraints force buyers to pay more. The median sales price for single-family homes was $750,000 (2.7% higher than December 2016) and for condos was $405,000 (3.8% higher than December 2016) in December. There is currently only 2.1 months of remaining inventory of single-family homes and 2.3 months of remaining inventory for condos. Stricter lending standards and the relatively unaffordable housing prices appear to be constraining price increases when comparing this current housing price expansion to the previous decade’s.

The University of Hawaii Economic Research Organization (UHERO) has predicted a ninth year of economic expansion at a more subdued rate. Tourism, fueled by a strong economy, additional airline capacity, and the proliferation of non-traditional accommodations (vacation rentals) will grow at about 2%. Average visitor spending continued to drop and the sheer volume of visitors has stressed Hawaii’s existing infrastructure. Total visitor spending is expected to increase about 1% next year. There will likely be many more discussions and arguments over the positive and negative impacts of tourism in Hawaii.

Hawaii’s construction cycle has peaked, but construction should remain strong over the next few years. Residential home construction in Central and West Oahu continued with high-rise construction in Kakaako will keep construction workers busy.

The pace of job creation has slowed due to low unemployment. The lack of productivity growth in Hawaii’s service-oriented economy will dampen wage gains in the current tight labor market. UHERO predicts income will rise 1% while inflation will rise over 3% due to high energy and housing costs.

A Mixed Plate of Talk Story

Outward migration and a strong economy have resulted in the lowest unemployment rate on record. Hawaii’s unemployment rate in November dropped to 2% and the pool of available workers dropped 1,100 from October to November to 670,300. The U.S. Census Bureau estimates that about 13,500 more people have left the islands for other states than have arrived from other states from July 2016 to July 2017 and about 37,000 people have left the islands over the past five years. The state’s chief economist stated that a robust national economy and the lower cost of living elsewhere in the U.S. are contributing to the net losses. A recent study conducted by Harvard University reported that about one-third of tenants must dedicate at least 50% of their take-home pay on rent. Stott Property Management, LLC, lost the services of one of its plumbers when he moved off island. Skilled repair personnel are becoming harder to find across the board resulting in longer wait times.

Zumper has confirmed what many property managers, including Stott Property Management, LLC, have noticed. Zumper recently reported that the median rent for a two-bedroom apartment dropped 11% compared to the same time last year. A second report by Apartment List reported a much smaller decline of 0.3% for one- and two-bedroom apartments. Stott Property Management, LLC has recently had to lower asking rents in order to find new tenants for several vacant properties.

Uber has reached an agreement with the state of Hawaii to pick up airline passengers at Daniel K. Inouye International Airport (formerly known as Honolulu International Airport). According to Uber, you can find directions to the pickup locations within the app.

Southwest Airlines has confirmed that it will start flying to Hawaii next year and is also eyeing the interisland market. The announcement came just before Island Air filed for bankruptcy. Island Air joined the ranks of Hawaii’s failed island airlines after closing its doors on November 10th after 37 years in business. Island Air accounted for about 5% of the interisland market while Hawaiian Airlines had 90% market share before Friday’s closure. Island Air had been profitable while operating older 40-seat aircraft and ran into trouble when those older planes had to be replaced with newer planes that seated many more people. Island Air was unable to keep the newer planes full and ultimately ran out of cash. Hawaiian Airlines and Mokulele Airlines are currently the only commercial interisland carriers as several competitors have failed to gain a foothold over the past decade.

Hawaii is expected to welcome a record, 9.3 million visitors, in 2017, a 4.5% increase over 2016 visitor counts. The Department of Business, Economic Development and Tourism expects another 2.3% increase in 2018.

Castle and Cooke Hawaii broke ground on Koa Ridge, a $2 billion project that will include 3,500 new homes once completed. The project has been stalled for 20 years as the developer had to push through three state regulatory proceedings and two Hawaii Supreme Court challenges. Affordable housing advocates don’t have to look very hard to realize that government red tape is primarily responsible for Hawaii’s housing shortage.

Homelessness continues to capture headlines in the local newspapers and an article in the Honolulu Star Advertiser highlights the need to roll back regulation and unnecessary red tape before meaningful relief can take place. An Oregon based developer completed a 209-unit apartment building, Keauhou Lane, and started taking applications in August for 167 apartments reserved for residents that earn no more than the median income in Hawaii. The remaining 42 are reserved for residents that earn no more than 80 percent of the median income. As of November 11, 2017, when the article was written, only 33 of the apartments have been rented. The developer’s director of property management points out that the city’s income verification process and documentation requirements create unnecessary bottlenecks and wait times for tenants seeking approval. What is more striking is that the rents for a studio start at about $1,400, don’t include utilities, and don’t include parking which is $145 more per month. Stott Property Management, LLC does not have one studio apartment on the island that it manages charging more than $1,350 and several of those studio apartments are located in Waikiki and include assigned parking.

Stott Real Estate, Inc. recently felt the impact of the lawlessness associated with Honolulu’s homeless population when a fire under the H-1 viaduct damaged communication cables supplying Hawaiian Telcom’s phone and internet services. The fire caused cellular, cable TV, phone, and internet disruptions throughout Oahu and on parts of Maui. Our office was without phones and internet for the entire day on November 16th. While the fire remains under investigation, officials believe that the fire was intentionally set. The state recently cleared out 2,050 tons of trash from the area at a cost of $516,000. The state completed its last large homeless sweep in 2017 at a bike path near the H-1 viaduct early this month. 70 people, 20 dogs, and 22 guinea pigs were occupying the area when the sweep began.

The State Tax Director resigned amid concerns over the progress of the department’s IT upgrade and after the consultant for the project accused tax officials of interfering with its independent assessment of the project. The tax department requested changes to the reports before it was made public; a request that the consultant stated was not standard procedure. The consultant was hired after a string of failed information technology projects at the state government level dating back several administrations. The first two phases of the tax modernization project have been completed with hearings on the problems related to the General Excise Tax modernization efforts. The latest report stated, “At present, the program is not operating in an optimal way. There continue to be a number of issues and risks related to the program execution that, if not addressed and remediated immediately, may have a significant negative impact on the program’s ability.” House Finance Chairwoman, Sylvia Luke, a frequent critic of the tax office stated that the report is “shocking and it’s sad.” Luke went further by stating, “It completely undermines the credibility of the report and what they have said in the past, and I’m not sure how the consultant can allow this to happen, and I don’t know how the Department personnel can ethically insert themselves to maneuver and manipulate the information in these reports.” Governor Ige tried to explain away the tax officials’ behavior by stating, “change is hard.”

The Honolulu City Council gave approval for the city to begin condemnation proceedings for an easement over a small lane off Portlock Road to restore public beach access. One of the property owners installed a new locked gate that effectively blocked access to the beach on the advice of police. The owner is objecting to the city’s efforts to condemn part of his property to restore access. The controversy highlights a risk associated with owning beachfront property, particularly when the public uses a portion of the land to access the beach.

Former HPD police Chief Louis Kealoha and his wife, Deputy Prosecutor Katherine Kealoha were arrested on Friday, 10/20/17, and appeared in federal court to face charges of conspiracy, obstruction of justice, making false statements and bank fraud. The former HPD police chief put himself on paid leave in mid-December when he was informed in writing that he was a target of a criminal investigation by federal authorities. Louis Kealoha retired in February and Katherine Kealoha was placed on unpaid leave on Friday, 10/20/17. Many consider the legal developments to be the most significant case of public abuse of power in state history.

The sound of church bells rang on Saturday, November 11, 2017, marking the 100th Anniversary of Queen Lili’uokalani’s death. When she died in 1917, church bells across the islands rang out over the islands she once ruled. Queen Lili’uokalani was the last sovereign of the Kamehameha dynasty that ruled the Hawaiian Kingdom since 1810. By the time that she became queen, a new Hawaiian Constitution had reduced much of the monarchy’s powers. When she tried to restore those powers, a coup supported by the U.S. Marines deposed her in 1893, and a provisional government was established about a year and a half later. The queen signed a formal abdication of her rule in 1895 but asked President Grover Cleveland to help restore her powers. The United States annexed Hawaii in 1898. Queen Lili’uokalani helped raise money for the Soldiers Chapel at Schofield Barracks, one of the churches that rang the bells on Saturday.

Taking care of Hawaii’s aging population has recently been getting more attention and divisions are occurring on similar lines as other recent contentious issues like vacation rentals and affordable housing. A cottage industry has been growing up in response to the expense associated with and lack of availability to traditional assisted living communities and nursing homes. The Honolulu Star Advertiser recently ran a front-page article concerning unlicensed elder care facilities called “aging in place” (AIP) facilities. The AIP model involves having a resident sign a residential lease and a separate agreement with a home health care company specifying a set rate each month for necessary care and assistance with daily living activities. The model appeals to many people that need assistance because they would rather live in a home environment and have help versus being forced to live in a nursing home. Homeowners have had an aging in place option available to them for years. The AIP proponents argue that this relatively new arrangement is more affordable and with more options than traditional licensed assisted living and nursing home options. Opponents of the measure claim that the lack of state oversight leaves unprotected seniors at risk of harm. Attorneys that have helped set up AIP facilities state that the arrangement complies with Hawaii law while some state regulators claim that the facility operators are trying to skirt the spirit of the law. Ultimately, the legislature and courts may decide if seniors that want assistance will be able to continue choosing where they can rent and choosing the type of care that they want at home.

Erosion, which accelerated this summer from king tides, has exposed concrete structures on parts of Waikiki Beach has forced the closure of an area at Kuhio Beach. The Waikiki Beach Special District Improvement Association, funded by a tax on commercial property in Waikiki, discussed replenishing the sand, among other necessary capital projects, during its first meeting on December 5th. The annual taxes generate about $600,000 per year to address Waikiki’s aging infrastructure. Severe erosion at Sunset Beach has forced the City and County of Honolulu to move a bike path closer to Kamehameha Highway, take down a storage shed used by the life guards, and move the life guard tower farther inland.   A 20-foot drop off now marks the area where winter waves removed tons of sand from Sunset Beach. The city is working with the state to come up with a long-term plan since the erosion is expected to continue and there are no easy solutions. City officials short-term goals consist of taking measures to keep people from getting hurt at Sunset Beach and other Oahu locations that have experienced significant erosion over the past couple of years.

Longtime Honolulu resident, Jim Nabors, best known for his role as Gomer Pyle, died on November 30th at the age of 87. Tim and Tracey attended a Merry Christmas show at the Hawaii Theatre starring Nabors. His tremendous singing voice and low-key nature endeared him to many in Hawaii and made him a local fan favorite.

Two Honolulu women were rescued from their disabled 50-foot sailboat 900 miles southeast of Japan after drifting for five months. The pair left Ala Wai harbor on May 3rd destined for Tahiti. The two survived by packing a year’s worth of food on the boat and brought along a water purifier.

Odds & Ends

The Tax Cuts and Jobs Act: This article is meant to highlight changes to the tax code in 2018. However, we are not licensed to provide either legal or tax advice. Licensed professionals like tax attorneys or certified public accountants (CPAs) should be consulted for advice.

The new law doubles the standard deduction to $12,000 for individuals and to $24,000 for married couples. A significant number of homeowners will no longer have to itemize their deductions. This will simplify the tax returns from some homeowners while providing a tax break for renters.

For those homeowners that will continue to itemize their tax deductions, the law limits interest from mortgages incurred after December 15, 2017 to no more than $750,000 that will qualify for the home mortgage interest deduction. Mortgages incurred before December 15, 2017 are unaffected (the $1 million limit still applies). However, interest paid on a Home Equity Line of Credit (HELOC) will no longer be eligible for the home mortgage interest deduction. The law still preserves the mortgage deduction for second homes.

State and Local tax deductions are limited to $10,000. Therefore, residents in high tax states may not be able to deduct all of their property taxes in 2018. Many Hawaii taxpayers will have a smaller deduction in 2018 due to this change in tax law.

The homeowner’s exemption for capital gains and the ability to defer taxes via a 1031 exchange did not change. Homeowners that have lived in a property two of the last five years will be able to exclude $250,000 in capital gains if filing single and $500,000 if married filing jointly.

The treatment of mortgage interest on investment property has changed and is more complicated. An investor’s net interest deduction will be limited to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) for the next four years and then it will be limited to 30 percent of earnings before interest and taxes thereafter. A rental property owner will still be able to fully deduct property taxes associated with their rental property. Depreciation for residential rental property has been extended from 27.5 years to 30 years and on commercial real estate from 39 years to 40 years.

The law also restricts taxpayers from deducting losses incurred in an active trade or business from wage income or portfolio income. As a result, real estate professionals should be aware of how this change might affect them in the future if they own investment real estate showing a net loss.

Oahu’s Appliance Challenge: Plan on installing stainless steel appliances if you are remodeling your Oahu kitchen in the near future. Major appliance companies are stocking fewer white and black models.

Tastes in the world of kitchen appliances have changed over the past few years and people who are contemplating a kitchen remodel should take notice. White and black kitchen appliances are out and stainless steel is in. Trying to replace a white dishwasher has frustrated Tim and Tracey over the holiday season. Neither Sears nor Best Buy had quiet (below 50 dB) white dishwashers in stock and it takes at three weeks to get one shipped from California. Waiting for an available plumber to install the dishwasher adds even more wait time.

Tracey has been willing to wait for an “acceptable” dishwasher since Tim has dish duty at the Kelley house. She commented recently on how frustrating it is to look at the pile of dirty dishes waiting to be cleaned.

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. 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. 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.
  2. 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 federal capital gains rate does jump to 20% above certain income thresholds depending on how you file. The Hawaii capital gains tax rate is 7.25% on all components of gain including depreciation recapture.

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. Five 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.

The example uses 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 exceedingly 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.