 and welcome to Inside Hawaii Real Estate, a community real estate show dedicated to providing up-to-date information used to Hawaii homebuyers, sellers, and investors. I'm Wotanaka with my co-host, business partner, and wife, Leonie Lam, a realtor with over 20 years of experience in various leadership roles in the Hawaii real estate industry. Thanks, Will. Will is a full-time realtor, a lawyer, a law school professor, and the former head of Hawaii Title and Astral Company. Together, as full-time realtor professionals, Will and I work as a team to bring you the latest in Hawaii real estate. So how well do you understand taxes? I don't know about you, but for me, I find taxes pretty complicated, and I'm always in awe of CPAs who are able to articulate tax matters, so they make sense to me. On this show, we're talking about taxes in Hawaii real estate investments, and our very special guest is going to help us to understand some of the basics. We're going to start with tax basis, gains and losses, depreciation, and the tax table, and probably so much more. Our local state expert, Hawaii CPA, Brad Konishi, was licensed in 2001 as a certified public accountant. He's an educator. He's a very, very trusted CPA in Hawaii, and he specializes his tax expertise as the president and owner of HARPTA Help LLC. They assist home sellers with all the many issues related to HARPTA and FERPTA. Will and I are so honored to have you as our guest. Welcome, Brad. Thank you, Will and the only. Thanks for having me back. Thanks for being back. We're so excited. Yeah, let's talk about taxes. Well, Brad, welcome again, and we often support sellers with the sale of their home, and tax basis always comes up, and it's a whole different world, this tax world. So let's get started with the basics of foundation. Would you help us better understand what tax basis is and why it's so important? Okay, sure. Well, there are actually a couple of numbers that are really important when calculating gain or loss for the sale of real estate, and one of those two numbers is your tax basis, in particular how it starts and how it's adjusted. So your tax basis is, it depends on how you acquire the property. For many people who purchase property, usually their original tax basis is whatever they pay in so far as their cost. But of course, people can come into property different ways. They can receive it as a gift, or they might inherit property, which also happens as well. So tax basis is one of those really important numbers that is really important to understand in order to understand your gain on the sale of your property. Okay, so you kind of talked about tax basis being established. It depends how you acquire the property. So how is it determined? What are the different ways? Okay, yeah, great. Thanks. For most people who purchase the property, like I said, their original basis is what they paid for the property. You pay 500,000 for rental property that you're buying. Your original basis is going to be 500,000. But sometimes people acquire property through different ways. If you inherit property, and this is something that some people understand about, what happens is when you receive the property, you receive it at something called the stepped up basis. So in the case of, say, a parent who's owned the property for many, many years, their basis might be really low because maybe they purchased the property back in the 1970s when prices were a lot, lot lower. But then as time went on and then finally maybe the parent passes away, what happens is the fair market value as of the date that the parent passes away is the new basis for the person who inherits the property, the beneficiary. And so that concept is known as the stepped up basis. And you usually determine that by getting an appraisal from a third party appraiser. Right. And that's called a date of death appraisal. That's correct. Okay. Okay. And there's parameters like you have to get it done within a certain time frame and things like that. Well, you know, I know that you can, you can actually have them done retroactively. We've had, you know, clients who actually didn't get a date of death appraisal when their parents may have originally passed away. But then, you know, now that they're faced with this tax quandary that you have to, you know, justify their stepped up basis, there's actually an appraiser in town that we go to sometimes that actually helps us get appraisals that are retroactive. I see. So they look back at the records of sales maybe during that time period and they're able to establish. Yes. Yes. And I know it's a little bit, a little bit more expensive because, you know, you can't actually go to the property and see what the condition is, right? Because it's been many years past. But nevertheless, it can still be done. Right. Okay. Is there anything else that they would need, you know, to be aware of if it was an investment property as it comes, as it pertains to this? Like, do they have to make sure they're current with taxes? Oh, yeah, yeah. That's another thing is sometimes, you know, when somebody sells rental property that they've inherited or maybe that they own themselves and they're not a resident of Hawaii, sometimes there's a withholding. The withholding is known as Harpta, which just stands for the Hawaii Real Property Tax Act. It's kind of a harsh withholding, a 7.25% of the gross sales price. But what happens is during the escrow process, when somebody's selling a home, the escrow officer will actually set aside that money. After closing, they'll send that money over to the state and then the state will hold on to it until the seller can prove that their liability is less. And if they want a refund of some of their money, they have to make sure that they're current with, you know, things like general excise tax, transient accommodations tax, which is a killer, right? 10.25%. And also Hawaii income tax as well. Hey, Brad. Yeah, just going back to the tax basis, how about you often have situations where they receive a gift from a family member, their parents, their grandparents. How is the tax basis determined in those type of situations? That happens quite a bit. You know, if somebody's still alive, I guess this is a definition of a gift as opposed to an inheritance. With an inheritance, somebody actually has to pass away first and then the beneficiary acquires the property. However, in the case of a gift, you know, both the giver and the receiver of the gift are still alive when the gift actually happens. So, you know, in the case of a gift, what happens is the beneficiary receives the real estate at the giver's basis. So if the giver, say, paid $500,000 for the property and their basis at the time of the gift was still $500,000, what would happen is the receiver of that gift would have that same basis. Their basis would also be $500,000. So the basis would just be carried over from the giver to the receiver of the gift. I see. So regardless of when it was gifted, it doesn't matter. It's when the gift or purchase the property. It's the giver's tax basis on the date that they give the property to the receiver. Got it, got it. Okay. So we started off with the tax basis and, you know, when we're determining taxes, there's something called the net selling price. So can you get into that a little bit? Sure, sure, sure. The net selling price is the other number that's really important for determining your gain or loss when selling real estate. The net selling price essentially is really simple. It's basically your gross selling price, whatever it is you're selling the property for, less certain expenses. Certain expenses like commission expenses, escrow fees, title insurance, transfer taxes, those types of expenses can actually be used to offset your gain and to lower your net selling price and get you to the point where your gain is reduced hopefully as much as possible. But yeah, those are some of the expenses that are allowed to be introduced into the transaction to actually lower your gain. Okay, so how does the calculation of the gain or loss work? This is tricky. First, it's important to understand that the gain is taxed at a marginal rate. And, you know, the rates I believe for Hawaii purposes are anywhere from 1.4 up to, I believe it's 1.4 up to seven and a quarter percent. Whereas for federal purposes, the capital gains tax rate, long-term capital gains tax rate is actually zero percent in some instances. It can be 15 percent or it can be 20 percent. So it depends, you know, for state and federal purposes, it's, you know, the capital gains tax rates are much higher for federal purposes than state. And long-term capital gains tax rates are usually generally lower than the ordinary income tax rates. And ordinary income tax rates are, you know, what you and I pay on our income, you know, our W-2 income or our self-employment income. Whereas capital gains tax rates are taxed at a little bit lower rate, which is preferable. Okay, so in terms of just talking about numbers, so we have the adjusted tax basis, net selling price. And how would you calculate gains or losses, you know, using like real-world numbers, like a million-dollar price, for example? Okay, that's, you know, million dollars is always easy to do the math in my head. That's great. Let's just say somebody is selling a house for a million dollars. Let's just say their net selling price is a million dollars. It's going to make it easy. Okay. But let's just say that they purchased, you know, the property, say 15 years ago, you know, when prices were much lower, let's say their basis in the property was 500,000. What happens is when you own the property, if you use it as a rental, which, you know, a lot of people do, if they're not actually living in a house and it's not a second home, which is, you know, fairly infrequent phenomena, they're renting it, right? Because, you know, if you got a property, might as well make money off of it. So they're renting the property, but when they're renting it, they have to depreciate this property. And the depreciation becomes actually integral into their basis. All the depreciation that accumulates during their rental period lowers their basis. And because it lowers their basis when they finally sell it, they're going to have more gain as a result of that depreciation. So let's just say after, you know, this 15 years of ownership that they're adjusted basis, you know, their original basis, you know, less all of the depreciation was, say, 500,000. So a million dollars in that selling price, adjusted basis, 500,000, you come up with a gain of about 500,000. So that's going to be taxed for federal and for state at different marginal rates. Okay. Kind of like that chart. So that's the tax basis, about 500,000, net selling price, a million dollars. So the gain is this half a million dollars. Exactly. And I should state that this applies to rental real estate, right? Because personal real estate, real estate that you actually live in, you know, there's a something called the gain exclusion, section 121, also known as the main home gain exclusion, where people who are living in the home as their main home may be given a really large tax break, but we're talking about that. We are talking about investment properties today. So, but I just thought I'd mentioned that because, you know, some people might be confused because a lot of people know about that main home gain exclusion. And so they might be thinking, well, you know, I shouldn't be taxed on all of this, you know, if it's a home that you live in, you may not be taxed on it at all. But if it's a rental property, you get taxed from the very first dollar of gain that you make. And Brad, you know, you mentioned depreciation. I remember prior to buying my first investment property, I always heard about depreciation, and I could never really understand the concept until I went through it myself. So can we get into the basics of depreciation and how that works for investment properties and tax benefits? Okay, sure, sure, sure. You know, that's a great example. And I think of all the areas of real estate investment, when it comes to taxes, this is the area that causes the most confusion, because I think the concept of depreciation works very differently from the way we think in the real world. But let me describe what depreciation is. When you own real estate, and you're using it as an investment, you're renting it out, what you need to do is the very first thing is you need to split your cost or whatever your basis is. You need to split it between land and building, because land does not get depreciated whereas building does. But as a concept, depreciation essentially is the recognition of an expense over a period of time that you're actually using the rental property, right? Because let's just say you purchase a real estate for a million dollars. It's going to be a rental real estate that you're going to rent out. You're not going to recognize all of that expense in the very first year, right? Or else it's going to be lopsided. You know, the benefit that you get from purchasing the real estate and then renting it out over time, those benefits are seen over time. So what happens is the IRS allows you to, well, forces you to recognize that expense over time. In the case of residential rentals, it's 27.5 years. So let's just say you bought a property, a million dollar property, but the actual building value, let's just say most of the value is in land, but the building value is $275,000. If you depreciate that over 27.5 years, that's going to be what, $10,000 per year of depreciation. So that $10,000 of depreciation is recognized. You put it on your tax returns, you get a benefit from that, and that's what depreciation would be. So that's the upside of depreciation is the expense that you get to lower your taxable income. The other side, the dark side of depreciation is what happens is as you're depreciating your property, you're lowering your basis. And when you lower the basis, what happens is when you finally sell, lowering the basis, if you remember the way that example looked, that creates a larger and larger gap that increases your gain. So yeah, depreciation will lower your basis, as you can see from that chart there. It'll lower your basis, but it increases your gain. Here's the kicker though. The IRS says, with depreciation, your basis is lowered by the depreciation that has been allowable or allowed. So even if you had depreciation that you could have taken but didn't take, you have to lower your basis when you sell by depreciation that you could have taken but you didn't take. So that's one thing to keep in mind. Make sure you depreciate because if you don't, you could find yourself really at the short end of the stick when you sell. And that's where you had kind of shared about certain clients, maybe like military clients and stuff, if they're not doing taxes with a professional that's advising them about depreciation, maybe they're doing it on their own that sometimes they miss out on that. Exactly. We've seen it a lot because you know at Harpta, that's one of the things we do is a lot of our clientele, we see people who've actually lived in the house first and then converted to a rental, particularly military. And it's hard because their circumstance a lot of times is they're getting PCS, so they're actually moving off Island while they're vacating their home and then trying to establish a new home and then trying to be assigned to new work while their children go to a new school and maybe their spouse has a new job themselves. So there's so many things going on that for them, they unfortunately don't have the time to research what's the proper way to convert a home for your main home into a rental. And so as a result, they might skip steps or they might not know exactly all the requirements that they have owning a rental property. So yeah, that's one of the challenging parts for a lot of our clients. So the bottom line is in terms of depreciation, you know, for investment property, I mean work with the CPA because I think you had mentioned like when you're doing your own taxes, TurboTax or whatnot and people are just trying to save money, there's a section on depreciation and they just kind of bypass that. Yes. So make sure that I mean, because from the higher standpoint, they're going to depreciate anyway, right? I mean, the value of your property. Exactly, exactly. So yeah, your basis is going to be lowered by the amount of depreciation that you took or that you could have taken. So if you know, the worst possible position to be in is you didn't take depreciation over that time that you had the rental and let's just say you had the rental over many, many years, you know, that's all the depreciation that you've missed out on for all those years that you operated the rental. And then when you go to sell, you got to lower your basis by the amount of depreciation that you didn't actually take but could have taken. I mean, talk about getting kicked in the face. The worst thing that happened and it just it breaks my heart. There are ways of making up that depreciation that you couldn't have you that you could have taken but you didn't take. That's just, you know what? That's a separate lecture. There's something called a Form 3.1.1.5. It's an IRS form. And I used to do this form, crazy, crazy long form. I think just the form itself is like somewhere around eight or nine pages. And so it's just... That's enough. Exactly. And that was just, you know, the separate form that gets attached to the Form 1040. But, you know, so I won't go into too much into that. But yeah, if you have rental property, depreciate or at least, you know, work with the tax professional the first year or two, get as much information from them. If you're a real cheapskate like I am, I'll admit it, right? You want to try to get the best value. And so a lot of times, you know, having a tax, you know, a CPA or an enrolled agent, somebody with a lot of credentials, it can be expensive to do it every single year. So maybe what you might want to do is maybe the first two years of your rental, go and see that person, the tax professional, ask as many questions as you possibly can. Once you understand the process yourself and how the process is reported on your tax returns, then maybe you can, you know, if you feel comfortable, you can do it yourself after that, you know? And then maybe every five years or so go back to the tax professional for a checkup, a little bit, you know? That's something that I, you know, clients used to do that with me when I did income taxes and that was just fine with me. I understood, you know, that's a good way to save money. You know, to pay $700 to $1,000 plus, you know, every year to a CPA to get your taxes done can be expensive. It adds up. How about if the investor owner does, you know, renovations on the property? Does that, that helps the tax basis to increase? Yes, it does. It does. You know, here's the thing is when they do improvements on the property, sometimes that, those improvements may get folded into the actual, you know, entire basis of the the home itself, or you might be able to depreciate those improvements over 15 years. You know, there's a separate category of improvement for 15 years. And if you can depreciate it over 15 years, great. You know, that's what some people do. Oh, that sounds good. And then you got to make sure to keep your records and everything because basically this form is, I mean, this, that amount of renovation work is kind of reported, right? On your tax form, but then it never got audited. Exactly. And, you know, that brings, that brings up a, you know, good, a good point, and that's retention, retention of records because this is something that, you know, I think a lot of people, when they hear about taxes and they hear about, you know, the IRS and getting audited, you know, the general rule is the IRS has about three years to argue. If they find evidence of fraud, they can go back as far as six years. There's no statute of limitations for, you know, forms unfiled. But a lot of people hear the three to six years and they think, oh, I'll be, you know, I hold my records for six years and then toss it out. I'm okay. But that only applies for, you know, things that have already been reported on your tax returns. Things like improvements that you've done, that you may hold for 10, 15, 20 years and become part of the basis of your property. Those types of documents, you need to hold them for three to six years after you actually sell that asset, you know, at the very minimum. So, you know, when it comes to record retention, we hear this a lot because, you know, sometimes when we're desperate to try to get somebody to, you know, change their game into a loss because we want to try to get them a heart to waiver, you know, we start asking questions about improvements. And one of the things we sometimes hear is, I don't keep those records, you know, that happened like, you know, 15 years ago, 20 years ago, I don't have those records. The unfortunate thing is, if you don't have records to justify that expense, you know, if you get audited, they're allowed to disallow it. So, yeah, that happens. Super good point. So, as we're in 2024, just kind of pivoting, are you as a CPA, as a tax professional expert, are you watching out for anything this year? Yeah, I think, you know, every year I watch for 1031s, what they're going to do at 1031s. They always talk about that. 1031 transactions are, you know, this kind of ties into what we're talking about because this applies for commercial or real estate investors, people who have rental property. 1031 exchange is a way that you can exchange rental property from one to another and not have to pay tax. It's a very, very powerful vehicle for investors. But every single time a new administration takes over or anytime there's a tax proposal that comes out, usually one of the first things that they put at the very top of it is that, yeah, we're going to do away with 1031s. But 1031s are still here for real estate and they haven't been done away with it. The reason why is when they take a look at this 1031s, and they look at not only the 1031 exchanges itself, but all the side businesses that have popped up because of 1031s and all the benefits that investors have because of the 1031s, eventually they decide to do away with it. And that's probably what they'll do again. But I always, always watch because something they always mention. Because you just never know. You just never know, right? Exactly. Just never know. And it depends on who the new administration is. Exactly. Exactly. But that's, you know, for new administrations, it's always tempting because if they did away with 1031, the tax savings, or the tax revenue, additional tax revenue to the government would be tremendous, you know. So because of that, that's a, I guess you would say on the proposals that they put forward, it's kind of a low hanging fruit because it's a number that's really large and really helps their case for more tax collections. But when they look at it, I think you try to take that away, the benefit goes away. It's actually probably less beneficial than actually having 1031 exchange. Okay. So we'll be keeping a close eye on 1031s and the new administration. And is there anything else that you're kind of tracking on for this year? Of course, I always look at the, listen to the proposals locally. One of the ones that has just been put forward by, I think it was Brenton Awa, who is, you know, he's really, really, I appreciate what he's trying to do for the real estate industry, make it for the locals, but he's trying to do some things with some of the taxation and make it difficult for foreigners or non-residents to purchase property in Hawaii. So that's one of the things that I was watching for. Got it. Got it. In terms of like the IRS budget staffing, that kind of stuff, why would that be important? That's another thing. For anyone who's worked in the tax area, it's no secret that the IRS has been starved for many, many years. And a budget cuts over the last decade have really, really cut back the amount of services that the IRS can provide. Many times as tax professionals, we find when we try to contact them, they don't pick up their phone, so we can't get answers a lot of times. So we've been seeing an uptick over the last year or so. And you know what? I've actually been seeing results, not too long ago. I had a problem that we had to iron out with the IRS for one of our FERPA clients. And I actually got a remote meeting where we scheduled something like this over camera where I spoke to an agent in Las Vegas. And by the time we were done with our meeting, our client's issue was all taken care of and they got their check within two weeks from that day. So it's getting better, but it's not to the point where it used to be where you could always call and speak to somebody. It's really difficult to get in contact with them. Well, it's good to hear that it's getting better. And, you know, Will and I always turn to Brad for any and all guidance or questions regarding Harpta and FERPA for our clients. Brad and his team, you know, as I mentioned earlier, they specialize in helping with any issues regarding Harpta and FERPA. Thank you. Brad is awesome. And, you know, thank you so much, Brad, for all your time and your energy, information. You're so valuable. So we really appreciate you. Well, thank you so much. So this is Will and Leonie on Think Tech, Hawaii Inside Hawaii Real Estate. We've been talking about taxes and investment properties with Brad Konishi, CPA, owner of Harpta LLC. So thank you so much, Brad and Aloha. Aloha. Thank you.