October-December 2018 Quarterly Newsletter

The December median price for single-family homes was $788,000 (5.1% higher than December, 2017) and for condos was $398,500 (1.6% lower than December, 2017). Demand in the form of the number of sales and pending sales continues to drop and supply continues to creep up compared to December 2017. The number sales for single-family homes dropped 28.3% and for condos dropped 4.6% while the number of pending sales for single-family homes dropped 23.7% and for condos dropped 12.7%. The number of active listings for single-family homes rose 17.3% and for condos rose 12.9%.

Hawaii’s population shrunk by a little more than 3,700 people in 2018, the second straight year of declines. 12,430 residents left the islands for the mainland seeking better opportunities in states with stronger economies. Hawaii’s workforce continues to shrink even faster as Hawaii’s population ages and people retire from the workforce.

The University of Hawaii Economic Research Organization (UHERO) predicts slowing economic growth over the next few years and sees no signs of an “immanent downturn.” The visitor industry will experience further gains in visitor arrivals but inflation adjusted spending growth will drop. Most gains will come from the Continental United States as a shrinking population will limit visitors from Japan and lower oil prices will affect Canadian numbers.   China has not developed into a major source of tourism as many had hoped over the past decade. Hawaii has seen the departure of a large number of military personnel and personal income is expected to grow a meager annual rate of 1% over the next few years despite record low unemployment. That will result in negligible purchasing power even with low inflation. We offer a monthly e-mail newsletter that contains additional local news and often includes photos, video, and useful links. Please e-mail us at home@stott.com if you would like to be added to the distribution.

 A Mixed Plate of Talk Story

The Hawaii Supreme Court invalidated the question asking voters to approve an amendment to the Hawaii Constitution that would allow the state to tax property in support of education because the wording on the ballot question was ruled unclear. Hawaii law requires that the language of a proposed amendment be neither misleading nor deceptive. The voting booths had notices stating that any votes for or against the measure on the ballots would not be counted.

The Hawaii Supreme Court ruled in favor of allowing the Thirty Meter Telescope Project (TMT) to begin construction once the necessary requirements of the state conservation district use permit are met. The state Office of Conservation and Coastal plans must approve TMT construction plans before construction can begin. The construction plans will be reviewed to make sure that they are consistent with the permit conditions and adhere to the Maunakea Comprehensive Management Plan that includes control of invasive species and attention to cultural protocols and training. Opponents of the project have already announced that they will make another stand on the mountain to halt the construction.

Hawaii visitors unfortunate enough to stay at five Waikiki hotels owned by Kyo-ya Hotels & Resorts fended for themselves and listened to aggressive Unite Here Local 5 union workers picketing the hotels during the 51-day strike. Sheraton Waikiki, Royal Hawaiian, Westin Moana Surfrider, Sheraton Princess Kaiulani, and Sheraton Maui were the first five of twenty hotels whose workers are represented by Unite Here Local 5 that had contracts expire this year and the union hopes to set the standard for the remaining contracts. Tourists paying pricey room rates had to do without housekeeping services and were asked to put out towels and trash in the halls. The hotels closed most restaurants, room service, and bar service. While some guests showed support for the workers, a large number of out-of-state visitors were angry with the workers when they were informed of the lack of service after checking into the hotel. Guests were awakened as early as 5:30 in the morning by chanting strikers picketing in front of the hotel and surrounded by picketing workers while trying to enjoy themselves on the beach. One woman left a message with the Honolulu Star-Advertiser stating that it was ridiculous that the hotels were expected to pay more than $50,000 per year for unskilled labor. She made less than the workers and saved years for a vacation ruined by the strike. The strike soured the American Dental Association’s (ADA) convention; the state’s largest during the last week in October and the ADA may consider a different venue after dealing with the disruption. Local politicians showed how much they take the tourist industry for granted by showing support for workers while failing to apologize to visitors who have had their Hawaii vacations ruined. The strike ended on November 27th when Unite Here Local 5 ratified a new contract. Oahu’s hotel occupancy fell below 80 percent in November for the first time since March 2017 as the workers strike caused declines in bookings and led to cancellations. Revenue available per room (REVPAR) fell over 3% due to the closure of some food and beverage venues at the affected hotels.

A North Carolina doctor and his wife filed a class-action lawsuit against Marriott International and Kyo-Ya Hotels and Resorts for failing to inform them of the strike before they arrived for their honeymoon. By the time that the couple arrived at the hotel, the strike had been going on for about one month. Tim and Tracey were a little surprised that the Waikiki hotels embroiled in the strike with Unite Here Local 5 were not warning visitors ahead of time and were not providing room discounts to customers for the lack of service. It seems that some customers have arrived at the same conclusion.

A plan to speed up the building permit processing won final approval by the Honolulu City Council on November 14th for one- and two-family homes over the objection of the Department of Planning and Permitting that has taken up to a year to approve building permits. One contractor testified that he had to lay off 30 of his 83 carpenters over the past year due to delays in receiving approval of permit applications. In typical bureaucratic fashion, the department claimed that shortening the review time and relying on licensed professionals to do their job and serve their clients would result in lower safety and quality. The city council recognized that city government must get out of the way to allow the private sector to help solve the housing shortage and affordability crisis on Oahu. Mayor Kirk Caldwell announced on November 28th that he would allow the bill to become law in 60 days without his signature. He announced that the city will hire four new plan reviewers starting in December and bring back former or retired staffers on 89-day contracts to work through the backlog. He stated a new policy of immediately rejecting incomplete plans and limiting the number of reviews for commercial and residential projects to three cycles. Caldwell also mentioned increasing the number of permits filed online for projects like installing solar hot water, or completing certain electrical work, plumbing, or repairs to single-family homes.

Mayor Kirk Caldwell’s comments during the news conference announcing the changes in building permit reviews at the Honolulu Department of Planning and Permitting (DPP) have caused concerns in the building industry that the city would deflect responsibility for the delays by blaming applicants and third-party reviewers versus taking a more customer centric approach and streamlining their processes and reviews. One contractor came to the conclusion that the mayor and DPP plan on reducing the backlog by simply rejecting applications. Some of the challenges that DPP face is that their department is spread over five floors of a municipal building and their computer systems and inspection tools are antiquated. Tim and Tracey have experienced the permitting delays first hand for a simple six-foot moss rock wall at the front and back of their property. The wall was completed in July and the building permits have still not been closed. A DPP contact told Tracey during a recent call that some “soil inspection” was still required before the permit could be closed.

Past Honolulu Police Chief Louis Kealoha and past Deputy Prosecutors Katherine Kealoha’s legal troubles have now ensnared Honolulu Prosecuting Attorney Keith Kaneshiro and two other deputy prosecutors. A Honolulu businessman has filed for an impeachment petition against Honolulu Prosecuting Attorney Keith Kaneshiro after media reports circulated that Kaneshiro received a target letter from federal prosecutors stating that he is a target of a grand jury investigation. The businessman has circulated a petition online and has collected 861 signatures eclipsing the required 500 signatures to submit a petition to the courts. The impeachment petition has been submitted to the Circuit Court and the judge will likely ask the state Office of Elections to certify the signatures. The first hearing was initially scheduled for January 8 2019, but it has been postponed until February 14, 2019 because Kaneshiro has not obtained legal counsel. In a shocking display of arrogance, Kaneshiro failed to show up at a December 28, 2018 conference and a city deputy counselor only showed to repeatedly state that he did not represent Kaneshiro. The businessman who filed the petition was indicted twice for distributing sweepstake machines that Kaneshiro’s office deemed illegal gambling devices and seized the machines from arcades around Oahu. Katherine Kealoha had filed both indictments and state judges dismissed both indictments. The businessman is seeking the return of the machines and is also suing Kaneshiro, Kealoha, and the city for malicious and retaliatory prosecution. The businessman claims that he was the only person indicted because he was the only person to ask for the return of the machines. The impeachment process is likely to drag out for months since the city and state processes or poorly defined.

Howard Hughes Corp. continues to build out Ward Village in Kakaako. The company broke ground on its fifth mixed use tower, the 751-unit Aalii, in November. While several of the other towers were aimed at the luxury and ultra-luxury market, the Aalii will offer more “moderately priced” units. Prices start in the $500,000s for a 300 square foot studio, in the $700,000s for one-bedroom units, and $1 million for an 850 square foot two-bedroom condo. An interior design firm was hired to provide turnkey furniture packages for some of the studios. While visiting the sales center, Tracey learned that part of the maintenance fee goes to power washing the Ward Village sidewalks every evening and for security on the grounds. Not surprisingly, Ward Village in Kakaako does not currently have any issues related to homelessness. The sales people have noticed a migration of some property owners in Waikiki, where the homeless population and crimes by homeless individuals have risen over the past decade.

Howard Hughes Corporation officially opened a privately owned public park in December, one month ahead of schedule with the introduction of a light garden consisting of 2,300 artificial flowers illuminated by about 25,000 LED lights that react to visitors walking by and to wind and sound. The one and half acre park will eventually be expanded to three acres and with walking paths, shade pavilions, and water features and host community events like yoga classes and outdoor movies. Howard Hughes also completed construction on its third tower, Ae’o, in December and new owners started moving into the condos priced an average of $1 million. E-mail us at home@stott.com if you are interested in the new developments at Ward Village and would like more information.

The successful planting of a test crop of oysters in Pearl Harbor’s West Loch is prompting a nonprofit, Waiwai Ola Waterkeepers Hawaii Islands to explore expanding the program to Maui’s Ma’alaea Harbor and the Ala Wai Canal. Introducing oysters is not harmful to the animals whose feeding process naturally filters the surrounding water. The shellfish absorb almost anything including pollutants. The useful materials are absorbed and help grow the oyster’s shell and the remainder is contained in mucus that sinks to the ocean floor.

The Volcano House, the one hotel in Hawaii Volcanoes National Park, fully reopened on October 25th, five months after Kilauea’s eruption forced both the park and hotel to close. The restaurant and lounge were the last pieces of the hotel to open because of issues related to the rapid evacuation of the site. The hotel needed to replace flooring and some appliances before the restaurant and lounge could be reopened. The Volcano House brings back many great memories for Tim and Tracey. They stayed there to celebrate their first anniversary and decided to travel for every anniversary. Ashley was born the following October and that decision was overturned. Tim and Tracey returned in 2000 with both Ashley and Mark, and Mark finished his first hike at the age of three without having to be carried. Hawaii Volcanoes National Park is one of those places that you can visit repeatedly and find some new adventure every time.

The University of Hawaii (UH) football team finished the season at 8 – 6 after losing to Louisiana Tech 31-14 in the 2018 Hawaii Bowl. It was the first time that UH has finished the regular season with a winning record in seven years.

The UH Wahine volleyball team lost 3-2 in the first round of the NCAA tournament to Baylor University on November 29th after taking the first two sets and being up 18-14 in the fourth set. The disappointing loss was the first against a Baylor team. The Wahine finished the season 18-9, finished 2nd in the Big West Conference behind Cal Poly, and participated in their 26th consecutive NCAA tournament.

Tim and Tracey flew to Lanai in November to celebrate their 25th wedding anniversary on November 12th. It had been 25 years since they stayed at the Lodge at Koele for their honeymoon. This time around, Tim and Tracey stayed at The Four Seasons Manele Bay because the Lodge is still undergoing renovations. While snorkeling, a Hawaiian monk seal meandered on by and stopped momentarily to check Tim and Tracey out before swimming off.

Successful Investors and Happy Home Owners

Tracey and I have been reading a book, The E-myth Revisited, by Michael Gerber who has made a career out of mentoring small business owners and helping them build great businesses. One of the paradigm shifts that Michael Gerber says must happen with most small business owners involves separating the small business owner’s sense of worth from the business. In other words, most small business owners will continue struggling or fail because the small business owner fails to remove him or herself emotionally from the business and view the business dispassionately through the lens of an entrepreneur. Most small businesses ultimately fail because the small business owner never set up the business to succeed without his or her involvement on a daily, personal level. Most failing small business owners wear out from the stress and effort of doing everything themselves.

We have been advising real estate investors to treat their investments as small businesses for 13 years and have owned investment property for 20 years. Stott Property Management, LLC’s happiest and most successful investor clients all share similar traits. They have no emotional attachment to the property, they make decisions based on how it affects long-term returns, they recognize that their rental property is simply a commodity and must compete accordingly for tenants, and they understand the value that they are offering their customer, the tenant.

By far, the clients that suffer most have an emotional attachment to their property. In some cases, they look at the property through the lens of their childhood experiences and don’t remember their parents’ efforts to provide a happy home. They expect their tenants to treat their property with the same reverence that they have while the tenants just see an old house that provides a roof over their heads. Every routine maintenance decision becomes an excruciatingly drawn out affair and every minor setback becomes a disaster. Stott Property Management, LLC recently had to give a property back to the owner of a house on the historic home registry that was in a neighborhood plagued by problems associated with homelessness. The owner was upset about normal wear and tear with some old dated wallpaper and some degradation in a concrete border for the driveway. The City and County of Honolulu advised the owner that this house made a poor rental property and revoked the historic home designation when the tenant locked the gate to the back yard to prevent the homeless people from harassing their children and from stealing items from the back yard. The owner would have made more money by taking the home out of the historic home registry, paid more in property taxes, removed the old wallpaper and painted the interior, and allowed the tenants to lock the gates and limit access to their yard. The property sat vacant for months when the owner tried to raise the rent on the existing tenants against our recommendation.

If you are thinking of renting a property that you are currently living in, ask yourself these two questions and answer honestly. Did you grow up in this home or raise your children in the home? Would you become extremely upset if a tenant did not have the same standards or attention to detail in caring for the home as you? If either of these answers is yes, then save yourself the suffering and sell the property when it is time to move.

Successful real estate investing is simply a numbers game where the winners collect more revenue than they pay out in expenses with minimum time and effort. Successful investors recognize that not all locations will offer good investment opportunities all the time and they only buy at a price that allows them to earn an acceptable return while hiring a professional to handle the details. If your goal is to eventually generate enough passive income to quit your day job, then you are going to have to work on your business and not in it. Please e-mail us at home@stott.com if you would like to us to give you the information necessary to make an informed decision regarding renting versus selling or if you would like us to provide our professional opinion regarding your current Oahu residential investment property.

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 or e-mail us at home@stott.com. If you provide us your e-mail address, we’ll e-mail or 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.
  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 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 1/1/98 for $200,000 and rents it for 13 years until 1/1/11 when she occupies it as her principal residence. Seven years later, on 1/1/18, 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 1/1/18 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 that is taxed at 25%.

In our example, we 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 3/7 or 43%. However, if it is rented for only one year and then occupied for six years, the non-resident use would only be 1/7 or 14%. 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.