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I PAY FOR MY OWN partial retirement with a university pension, income from rental properties, income from the remnants of my private psychology practice and, of course, Social Security. I long ago emptied my retirement accounts to pay for our son Ryan’s college education and to help launch his career.
What about my wife Alberta? She has income from her fulltime psychology practice, her share of our rental income and Social Security. But unlike me, Alberta is also awash with traditional retirement accounts, where all withdrawals are taxable as ordinary income. She has a Roth in name only because, as we say in Yiddish, it’s “bupkes,” or hardly anything at all.
Too many decades ago, we opted to forgo funding Alberta’s Roth in favor of investing in rental real estate. Property owners, like stock investors, have enjoyed a bountiful if bumpy long bull run. But our zeal to redirect excess cash to real estate rather than stocks was overdone.
Now, more than three-quarters of our combined wealth sits in relatively illiquid rental properties. After 40 years of uninterrupted appreciation, selling would mean big tax bills—or, at least, it will until my passing means a step-up in basis on the properties and hence relief from the tax burden.
Here in California—a community property state—my death will eliminate the entire embedded tax bill on our jointly owned properties and not just half, which is the case in most states. Still, in retrospect, adopting my parents’ investment ideology, that owning real estate is the gold standard for retirement, wasn’t the wisest course of action.
I have concerns about Alberta’s income once she decides to stop seeing patients and if she lives well into her senior years. Perhaps greedily and unrealistically, we’re reluctant to cut back our (hardly extravagant) lifestyle at this late stage. Still, that means we’re currently a little strapped for cash unless we start withdrawing from Alberta’s traditional retirement accounts. Her upcoming required minimum distributions may, ironically, force our hand at just the right time.
As the money nerd in our relationship, I manage Alberta’s retirement accounts. I rely almost exclusively on exchange-traded funds (ETFs), largely because of their liquidity, low cost, and freedom from the cumbersome and annoying restrictions that fund families sometimes impose on mutual fund investors.
I have dual and sometimes conflicting goals, aiming both to generate income for us and to increase Alberta’s portfolio for our son Ryan’s eventual inheritance. Since both Alberta and I are in our 70s, I’ve embraced a moderate growth strategy. I aim for an overall dividend yield above 3% and a total return that’s two-thirds of the broad market’s advance or decline—similar to the goal I have for my taxable account.
To that end, I’ve invested Alberta’s retirement accounts in two core low-cost Vanguard Group ETFs: Total World Stock (symbol: VT) and International High Dividend Yield (VYMI). Together, they represent a third of Alberta’s portfolio.
I’ve bought eight other ETFs for Alberta. In the interest of diversification, only two account for more than 10% of her portfolio: Technology Select Sector SPDR (XLK), a meat-and-potatoes sector ETF, and Schwab U.S. Dividend Equity (SCHD), a dividend-and-growth ETF with enviable 10-year relative performance.
Two of the other six funds deserve special mention. Avantis U.S. Small Cap Value (AVUV) has a promising record since its inception four years ago, and it lost only half as much as its Vanguard peer (VBR) in 2022’s market bloodletting. Although an actively managed ETF, it has an uncharacteristically low 0.25% expense ratio and only 24% turnover. Meanwhile, Vanguard Real Estate ETF (VNQ) seems like a timely investment after a stretch of weak performance, plus it offers Alberta an opportunity to become comfortable with real estate investment trusts, should she ever decide to relinquish direct real estate ownership in favor of this hassle-free alternative.
For insights into Alberta’s fund mix, I give thanks to Morningstar’s Portfolio Manager platform, especially the Portfolio X-Ray tool. To make sure I’ve achieved a desirable amount of diversification, I use Portfolio X-Ray to check what percentage of Alberta’s 
overall fund mix is in each of Morningstar’s nine style boxes. You can see the result in the accompanying chart.
My goal is a sensible allocation, with a slight value tilt and meaningful small and midcap exposure, and that’s what the portfolio has. Morningstar’s X-Ray also tells me that international stocks comprise an intended one-third of the portfolio. The average cost is 0.18%, which I consider very acceptable, although it may not satisfy a Bogle purist. The technology allocation is 24%, compared with the S&P 500’s 29%, a deliberate underweight dictated by my anxious temperament.
What about that Holy Grail called performance? As a benchmark, I use 70% in a total U.S. stock market index fund and 30% in a total international stock fund. Over the past year, Alberta’s portfolio earned 69% of the benchmark’s return, in line with my target of capturing two-thirds of the overall market’s movement.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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Years ago I thought a lot about RE(real estate). I read many books, got a license as a RE appraiser, and discussed it with many RE owners.
I came to several conclusions:
1) RE is too complicated with too many moving parts. You have to take a loan, rent the place, collect rent, fix stuff, and sue tenants. You have to deal with vacancies, taxes, attorneys…
2) It takes too much time
3) You have to worry
4) You have to do everything right, from buying to renting, fixing, and more
5) If you want to make it, you have to put in the time and effort. I already had a good job, I don’t need another.
Bottom line
None of this interests me and why I only invest in mutual funds and ETFs.
These funds don’t talk back to me. I can replace any fund within 2 minutes of work.
I didn’t even buy a REIT fund over the years, since REIT is a very narrow sector and can’t beat tech long term.
Anyone who invests in the SP500 had a pretty good return over the decades with zero work, RE success? not a “sure” thing as the SP50.
BTW, my thinking from the start was always to keep our lives simple. We owned our home and 2 vehicles but never owned a boat, a rental, or a timeshare. If we need any of these, we just pay for it which is a pretty easy concept and lets you sleep well at night.
Always enjoy your articles. As with most HD articles, the specifics of your situation are not applicable to me. I very much appreciate how you analyze issues and devise your solutions based on wide ranging available information. Thank you.
How nice of you. Thank you. Especially with a technical article like this, I never know how many people I’m reaching.
75Pct in one asset class seems risky to me.
There are several points to consider.
1- Step up rules could be adversely modified
as part of an estate tax overhaul after
12/31/25.
2- California has numerous issues and is
losing population – at some point residential
real estate could be affected
3- There could be an increase in capital gains
taxes in the next Congress – not likely
but possible.
The Yiddish phrase in this case would be
“ferkauf and antlauf” (sell and run away) –
until you achieve a 50/50 balance
A resolution for all of this: “Man plans and God laughs.” Take care
I think the analysis is not so complicated.
You invested in these properties primarily
for yourself and your wife, not for an inheritor.
if you need the funds and a sale will generate
cash, it makes sense to sell.
As there are several properties, you can
sell them off over a number of years –
not an all or nothing decision.
I will add that it doesn’t have to be an all or nothing deal to sell the real estate, with the typical high closing costs. I’ve sold a lot of real estate on land contracts, where I tote the note. The big advantage is low selling costs, assuming that you do most of the leg work, plus a small fee if you hire an attorney to draft the contract (which you can reuse for the next one by changing the relevant info). The primary advantage has been a much higher interest rate than I can get at the bank, plus capital gains and recaptured depreciation are only recognized as a percentage of the principal payment each year. The risk is selling to a qualified buyer that will take care of the property and make the payments as agreed, but for me, the benefits have far out weighed the risks. Yes, you may occasionally get a property back, if you didn’t properly screen the buyer, but in general, it’s a win/win for both parties as you get a higher price than you might otherwise get, plus enough of a down payment so the buyer has skin in the game, then monthly P&I payments for years to come. Most people that I know that are professional or semi-professional RE investors do quite a bit of business this way. Just something else to consider.
You make sense again, but with some caveats: We will need to start taking RMD’s in a few years and as I said in the article that could be a “natural” source of cash available. Selling stock involves far less hassle and is free of commissions (and “closing costs.) If we sold real estate, your one-at-a-time approach would work except for having to pass up the stepped-up basis opportunity Alberta would enjoy if that property were held until my death. Remember, the stepped up basis would also apply to her heir (our son). Even if we took one of the least valuable properties, the capital gains tax on 40 years of appreciation and depreciation payback would, without the stepped up basis, be prohibitive and impractical.
Do you actually approach all this as Alberta’s income as opposed to our income using combined assets for the family?
I don’t understand that approach in a marriage, if that is the case.
Maybe I could have been clearer. What are Alberta’s alone are the tax-advantaged plans to which she has contributed from her private practice for 45 years. We both regard them as “her” assets, though as you say, once they are withdrawn we will both enjoy the assets and the income they produce together.
Steve, Have you considered selling the rental properties and deferring capital gains taxes by using the 1031 Exchange along with buying like kind commercial properties thru the DST(Delaware Statutory Trust ) vehicles. That way you can defer taxes, move from active to passive management, and allowing your heirs to sell the units with a stepped up basis resulting in far less capital gains.
I am interested in this type of 1031 exchange and would be interested if any readers have experience in investing in DSTs.
I feel the $240 per year cost of the premium membership is worth every dollar just for the portfolio X-ray feature alone. Every quarter I manually update my fund/ETF balances then check the data the X-ray feature provides. When my positions are off a significant amount relative to my preferred asset allocations I rebalance. The investing articles (especially Christine Benz’s) are also very insightful.
I totally agree. I’d throw in John Rekenthaler with Benz. He’s a brilliant research analyst and I’ve learned a great deal from him…… at least as much as I can understand!
I agree about JR
Your columns are always very interesting.
But I am puzzled as to why real estate
purchased at reasonable prices many years
ago would not have healthy free cash
flows at this point to support spending needs.
That’s a really good question. It does but it doesn’t! Of course, it does to some extent. But, remember we own small residential income properties including single-family homes, not commercial, and they don’t throw off the same percentage of income. They’re largely a play on capital appreciation, which has been very rewarding over the 40 years, but is not cash in hand unless we sell and give up the benefit of a future stepped up basis. And our rent flow must cover the unusually high income and property taxes in California. It’s a problem very similar to the one faced by the retiree who must decide whether to sell off stock to enhance cash flow and cover withdrawals. And then, let’s face it, we’re stubborn, have lived somewhat below our means for many years, and think “now it’s our turn!”
Yes, I’d ask the same question. As I recall from prior articles, you have at least 6 and probably more like 10+ units. This should generate plenty of cashflow, I’d think, particularly at CA rental rates. The only reason they wouldn’t, that I can see, is if you still have substantial mortgages on them, such as maybe you did cash out refi’s, which doesn’t sound like you based on your prior articles.
Also, if you have lots of equity, but don’t want to sell because of capital gains and recaptured depreciation taxes, there are ways that you can sell and invest in 1031 REIT exchanges, to simplify management and provide truly passive cashflow for your wife. I think, from prior articles, that you self-manage, so that’s definitely an issue for your wife if something happens to you, but if you don’t have any mortgage payments, there should be plenty of cashflow to pay a property manager to do it for you. That’ll typically cost you around 20% by the time it’s all said and done, but that’s still great cashflow.
I do realize that at 40 year’s you’ve used up all of your depreciation expenses, so this recapture would be rough if sold and the proceeds pocketed, but this just makes a 1031 even more attractive. Revenue generating real estate is still by far one of the best investments out there, in large part due to the tremendous tax benefits related to it, with write offs, depreciation and not needing to pay self-employment taxes on the revenues, etc.
In 2017, Congress took away the 1031 exchange for everything except real estate, I suspect in large part because most of them have substantial RE holdings and they wanted to retain that benefit for themselves. But it still exists for investment real estate, so it makes a lot of sense to take advantage of it, if you really want to sell them, so that you can benefit while you’re still alive.
I’ve been an RE investor for more than 25 years, so I understand the tax hit that comes when you use up the depreciation (27.5 years residential, 39 years commercial), but the cashflows from paid-for rentals allowed me to retire 5 years ago at 56 and be a snowbird, leaving the Midwest snow behind in the winter. I can manage the property manager remotely, as well as managing the maintenance and repair, so it’s been a great thing for me. Plus I’m one of those guys that has to do something productive with my time anyway.
What else could have have invested in back in the 90s, starting with less than $8k out of pocket, and creating a nice mid 7 figure net worth and 6 figure annual income? All without touching any retirement accounts or SS as of yet. Yes, for about 20 years I essentially had 2 jobs, so there was a significant sacrifice in time and effort, but our monthly income, which is more than twice our actual taxable income after various expenses and deductions, provides exceptional free cashflow at this point.
Thanks Myron, I agree that property is good… LONG term investment strategy. When we moved to another home in the early 80’s we just offered the old, paid off home for rent. The money helped pay the next mortgage, so we did that again eventually.
In the late 90’s she decided to take her share and run, so now, early 20’s I find myself with 3 homes that are paying off my last recent purchase from 22. The tax guy was surprised to find me buying a new home at such an age. I would be 101 years old if I just let the mortgage play out, not me! Without having a mortgage monkey on my back, I can offer reasonable rents to good folk making landlord life easy. I don’t have to use any rent proceeds for myself. So, reinvesting in doing upgrades to a house makes the value rise, and gives my people a better home.
My idea is to have my two sons takeover the homes eventually and they can enjoy the investment. They are very capable of doing the rental business and could offer my personal home as another, as they see fit.
Steve, I enjoyed reading how you’ve structured you investments and Alberta’s. When you’re in your “golden years”, as we are, with a number of long held investments, the capital gains considerations really are significant. They make it awfully hard to simplify your portfolio.
You also highlight the stepped up basis at death, including the advantageous rule for community property states such as California (and our home state, Texas).
As for your extensive real estate holdings, I’ll venture a guess that your wife would rather not deal with the hassles. If that’s the case, is it your plan that she begin selling off the properties at your death, with no capital gains—or maybe actual losses once the costs of sale are figured in—and be well on her way to a streamlined portfolio?
Even so, I’m also guessing that may take a while. My wife’s father owned a number of rental properties, and when he died my wife and her siblings inherited them. My wife was also the executor of his estate and she kept the estate open until she could liquidate every one of the properties.
She was a superb executor and marketed the properties very aggressively. Nevertheless, it took several years to sell them all. The local real estate market was fairly flat at the time and so there was a modest capital loss on each of them once the sale expenses were added to the stepped up basis.
And when that last rental property finally sold, I can tell you that we broke out the champagne!
A great (if painful) real-life story I will definitely share with Alberta. I hope your wife’s siblings appreciate her loyalty—a lesser person might have let the properties go more quickly and cheaply for all concerned. I guess the amount of the “stepped-up” tax savings has to be weighed against the daunting responsibilities of serving as an executor of a large estate. Being “designated to serve” is considered an honor in our society. But it also brings daunting responsibilities and tolerance for family squabbles that intensify at a parent’s death. Alberta sometimes wonders if she would have preferred to have a sibling or two, but your comment may succeed in putting that fantasy to rest!