Welcome back to the Deep Dive. Today, we're taking
on a term you've definitely heard before, probably
a thousand times if you spend any time online,
passive income. Oh, absolutely. It's everywhere.
It is. It's sold to us as this golden ticket,
right? The shortcut to financial freedom. Yeah.
You see these images of people on a beach with
their laptop. And the idea is money is just.
flowing into their account while they're, I don't
know, hiking in Peru. It's a powerful marketing
hook. I mean, who doesn't want to separate their
labor from their livelihood? That's the dream.
But that dream, that marketing hype, it runs
into a brick wall. The brick wall of reality.
The brick wall of your accountant and, more importantly,
the tax authorities. So our mission today is
to really cut through all that noise. We're going
to dive into the precise, the technical, and
frankly, the often extremely narrow definitions
of passive. of income. Especially how governments
like the IRS here in the U .S. actually see it.
We're separating the beach fantasy from what
you actually put on your tax forms. Exactly.
From the Instagram post to, say, Form 8582. OK,
so let's build this from the ground up. Our sources
for this are pretty technical. We're not giving
out investment tips today. We're trying to understand
how the system actually defines the money you
earn. Right. And to do that. we have to start
with the most fundamental technical definition
from the material we have. Officially, passive
income is a type of unearned income. Unearned.
That sounds a little negative. It's just a technical
term. It means the income is acquired with, and
this is the key phrase, little to no labor to
earn or maintain it. And that's... after the
initial asset is in place. After the asset is
set up, that's an important distinction. A critical
one. It's usually combined with your regular
job, your salary. But the single most defining
feature is that you, the beneficiary, get this
income regardless of your ongoing material activity
in whatever is creating the revenue. And that's
the whole point, right? That separation between
your personal time and your personal revenue.
It's what makes it the holy grail for the whole
FIRE movement. Financial independents retire
early. Absolutely. If you're passive, income
streams cover your monthly expenses, your monthly
nut, you are by definition financially independent.
It cuts the cord. So it's really about owning
capital, not selling your time. Precisely. At
its highest level, that's what it is. It's about
leveraging ownership. OK, so our source material
lays out the big classic examples. I see three
main buckets here. First is owning financial
assets like an index fund that pays out dividends.
The classic portfolio stuff, yes. Second, rental
income, you know, owning a property and having
tenants. And third, and this one's a bit more
vague, it's profits from a business where the
owner does not materially participate. The silent
partner. You put in the money. but you're not
running the day -to -day operations. And this
income, it doesn't always look like a regular
paycheck, does it? The sources say it can come
in different forms. Right. It can be a big lump
sum. Think about an inheritance. Or maybe you
sell a piece of property that's appreciated massively
over 20 years. That's a huge injection of passive
capital. Or it can be a steady stream. Or it
can be a stream, paid out over time. And this
is where it gets kind of wild. Our sources point
out this stream can potentially last for centuries,
across generations. Centuries? Think about it.
A huge portfolio of dividend -paying stocks,
or a well -located piece of real estate in a
major city, or even certain kinds of debt instruments.
These assets can just keep generating income
indefinitely. It basically makes a family wealthy
just for the act of owning the capital that generates
the return. That idea of income lasting for centuries,
that leads directly to the big critique of this
whole structure, which you flagged in our prep.
It really does, because this is where the politics
and the economics of it get very, very real.
The source material we have highlights this major
critique. Passive income structures are often
used as, let's be blunt, sophisticated tax avoidance
schemes. Mostly by people who can afford the
lawyers and accountants to set them up. Exactly.
High net worth individuals who can structure
their income so it qualifies. capital gains or
these specific passive activities, which are
often taxed at a much lower rate than the salary
you earn from your job. And that gets to the
fairness of the whole tax system. It's the absolute
heart of the debate. The critics argue that because
this capital -based income can avoid the highest
tax brackets, the personal income tax itself
has been, well... They argue it's basically become
a wage tax. A wage tax. A tax aimed almost exclusively
at the middle and upper middle working class,
people whose wealth comes from their salaries,
their wages, their bonuses, all of which are
subject to those higher progressive tax rates.
Capital gets a discount. Labor pays the full
price. We're going to see this theme pop up again
and again, especially when we look at different
countries. That's a powerful framework. So with
that critique in mind, let's start breaking down
the different types of income. To understand
what's passive, we first have to understand what
it's not. Right. Let's start with its polar opposite,
active income. The one we're all very familiar
with. The one most people live on, yes. Active
income is, simply put, income you get from performing
a service. It's trading your time and your skills
for money. So your salary, your wages, tips if
you're a server, bonuses. All of that. And importantly,
self -employment income. If you're a freelance
writer, a consultant, a plumber, that's active
income. It also includes any money you get from
a partnership or an S corporation if you materially
participate in the business. There's that phrase
again, materially participate. So let's use your
plumber example. If I start a plumbing business
and I'm the one showing up to houses, fixing
leaks every day. That's my active intent. Literally
active, yes. But if I just invest in my friend's
plumbing business, I give her the startup capital,
and I just get a check every quarter without
ever touching a wrench, that's leaning passive.
Exactly. The entire distinction hinges on that
one concept, material participation. The income
is active if you meet the requirements, which,
as we'll see later, are often based mainly on
the number of hours you work. If you're involved
in management and daily operations and the big
decisions, you're active. If you're just a checkbook,
you're passive. Okay. So that's the active pull.
Now, what about the category that gets confused
with passive income all the time? Portfolio income.
Right. And it's an easy mistake to make. Portfolio
income feels passive. It's the purest form of
your money working for you. It comes strictly
from holding financial assets. Dividends from
stocks, interest from a savings account, or a
bond. Capital gains when you sell a stock for
more than you paid. and in some cases, certain
kinds of royalties. It's all income from capital,
not labor. But here's the first big technical
trap, especially for our U .S. listeners. A financial
advisor might tell you your dividend checks are
passive income, but the IRS sees it very differently.
Very differently. This is probably the most important
distinction we'll make today. The U .S. tax code
has a super narrow category called passive activities.
Portfolio income, your dividends, your interest,
your capital gains is not in that category. It's
in its own bucket. Its own separate bucket. And
this matters immensely because in the U .S.,
portfolio income often gets preferential tax
treatment. Long -term capital gains and qualified
dividends are taxed at much lower rates than
your salary. Which brings us right back to that
wage tax critique. It's the mechanism for it.
The tax code explicitly creates a financial incentive
to earn money from capital portfolio income over
earning it from labor or active income. Okay,
now let's tackle the new kid on the block. The
one that all the online influencers are talking
about, this idea of leveraged income. Yes. The
e -book, the online course, the software tool.
Leveraged income, as our sources define it, is
when you invest your labor once to create an
asset that can then be sold over and over again.
So the work is all up front. Exactly. The work
is front -loaded into creating a scalable product.
You might spend, say, 500 hours writing and filming
a professional video course. That's a huge amount
of active, difficult work. No question. That
is not passive. Not at all. It's a grind. Once
that course is uploaded and the sales funnel
is built, the revenue can, in theory, flow in
with minimal ongoing effort. You might answer
a few emails, maybe update a video once a year.
But the income stream is effectively decoupled
from the time you spend generating each new sale.
So is it passive? It feels like it breaks the
definition. It's a hybrid. It's a fascinating
modern creation. It requires a ton of active
labor to earn the asset. But the money it generates
afterward behaves a lot like passive income.
The key thing for, you know, that e -book offer
to remember is that while the income might feel
passive, the tax authority is probably going
to view the initial money from it as being fundamentally
tied to your labor. It really disrupts that old
school capital versus labor split. That distinction
is so important. It reminds you that passive
doesn't mean the money just appeared from nowhere.
It just means the person receiving the check
wasn't the one who performed the final piece
of labor that generated it. The stockholder getting
a dividend. Exactly. Take some giant multinational
company. You own a few shares. When you get your
quarterly dividend, that action is completely
passive for you. You did nothing but own the
stock. But that dividend was only possible because
of the constant active work of tens of thousands
of employees. The people on the factory floor,
the sales team, the engineers, they're all earning
active income for their labor. The passivity
is just a function of your position on the balance
sheet. You're an owner of capital, not a seller
of labor. OK, let's circle back to rental income,
because I think for a lot of people, that's the
one that feels the least passive in the real
world. You own a duplex, you get the rent checks.
Great. But then a tenant calls you at three in
the morning because the basement's flooding.
That's work. And it's often hard, stressful work.
Our sources are clear that rental income does
require managerial and custodial duties. That's
the friction. That's what makes it feel active.
But the key difference here, the thing that preserves
its passive status, is the ability to outsource.
You mean hiring a property manager? A property
manager, a leasing agent, a handyman on call.
All of those people are earning active income
for their services. But if you, the owner, can
pay them to handle everything, your profit stream
can remain entirely passive. So the calculation
for the investor is pretty simple then. It is.
Does my monthly rent check cover... The mortgage,
the taxes, the upkeep, and the cost of paying
someone else to manage it all. If the answer
is yes, you have a passive income stream. And
if you have to manage it yourself just to break
even... Then you're spending significant time
on it, and the IRS is going to look at that much,
much more closely. Outsourcing the management
is the key to true passivity in real estate.
This feels like a good place to transition. We've
defined the landscape active portfolio, that
leveraged hybrid, and the technical definition
of passive. Now let's get into the practical
applications, the four core sources for building
this kind of capital -based income. Right. Let's
move from the definitions to the actual assets,
comparing the risks and rewards. And let's start
at the absolute bottom of the risk ladder, deposits.
Safe, stable, but maybe not that exciting. Not
at all exciting, but foundational. For a lot
of people, this is their first and only source
of passive income, the interest they earn from
a high -yield savings account. You put your money
in the bank, and the bank pays you a small amount
of interest each period. It's simple, it's liquid,
and it's usually insured up to a certain amount.
Very low risk. And a step up from that, still
in the safe zone, are certificates of deposit
or CDs. Right. CDs are a commitment. You agree
to give the bank a fixed amount of money for
a fixed period of time. It could be six months.
It could be five years. And in exchange for locking
up your money, you get a better interest rate,
usually a much better rate than a standard savings
account. They're great for capital preservation.
If you have money you absolutely cannot afford
to lose, but you want it to earn a little more
than it would in a checking account, a CD is
a solid choice. But they are very strict about
that time commitment. Oh, yeah. Try to pull your
money out early, and you'll get hit with a...
pretty significant penalty. The whole model is
based on them having your capital for that guaranteed
period. And the formula is simple. The more money
you put in and the longer you commit to leaving
it there, the higher the interest rate they'll
offer you. So the verdict on deposits is they're
a great low -risk anchor for your finances, but
you're not going to get rich off of them. The
opportunity cost is high. Precisely. You're trading
growth potential for safety and stability. Okay,
let's climb that risk and reward ladder. Next
up. stocks. This is the main engine for wealth
growth for most investors. For sure. Stocks are
where you can really see portfolio based passive
income take off. And you make money in two ways
here. The first is. Value growth or capital appreciation.
You buy a share for $100, the company does well,
and now it's worth $150. And the second way is
dividends. Right. Dividends are when a company
takes a portion of its profits and distributes
it directly to shareholders. That's a cash payment,
usually every quarter, that you get just for
owning the stock. But investing in stocks, even
a broad market index fund, is a whole different
world of risk compared to a CD. A completely
different universe. Stocks are volatile. Prices
can swing wildly based on economic news, market
sentiment, a bad earnings report. Our sources
even specifically call out the risk of so -called
value stocks. Why are those? They're stocks that
seem undervalued by the market. They might have
a lot of debt or uncertainty about their future.
Investors buy them hoping for a big turnaround,
but the risk of them failing is substantial.
This is a game for people who are tolerant of
risk, who can stomach seeing their portfolio
drop 20 % and not panic. But the upside is that
over the long term, stocks have historically
provided returns that significantly outpace inflation.
That's the tradeoff. And within stock investing,
the sources highlight a really powerful passive
strategy. Dividend reinvestment plans or DDPs.
DDPs. How do they work? It's a beautifully simple
and totally passive mechanism. Instead of the
company sending you a check for your dividends,
that cash is automatically used to buy more shares
of that same company. So your ownership stake
just keeps growing on its own. It compounds.
The new shares you just bought then earn their
own dividends, which then buy even more shares.
Over 20 or 30 years, this process can dramatically
accelerate your wealth accumulation, all without
you having to lift a finger or invest a single
new dollar. It's the ultimate set it and forget
it strategy. OK, so we have the safety of deposits
and the high risk, high reward world of stocks.
What's in the middle? In the middle, we find
bonds. which our sources describe as reliable
debts. Reliable debts. I like that. So what is
a bond fundamentally? It's just a loan. You,
the investor, are lending money to a big entity.
It could be the federal government, your city,
or a huge corporation like Apple. That big loan
is just chopped up into small tradable units.
And the details of that loan are all spelled
out. Everything is spelled out. There's an issue
price, a face value, which is what you get back
at the end. There's a coupon rate, which is the
interest rate. And there's a maturity date, which
is when the loan is fully repaid. So the passive
income stream is that interest. It's the coupon
payment. You get a fixed interest payment at
regular intervals, say, every six months until
the bond matures. At maturity, you get your original
principal back. It's a very regular, very stable,
very predictable way to build passive income.
And in terms of safety, where do they fall? They
are arguably the safest financial instrument
you can buy. Outside of, you know, an insured
bank deposit. Much less volatile than stocks.
But, of course, with that safety comes lower
returns. The classic risk -reward spectrum. It's
always there. That's why the standard financial
advice for someone trying to build a balanced
portfolio is to own both stocks for growth and
bonds for stability. And it's worth noting, you
can sell bonds before they mature, just like
stocks. If interest rates fall after you buy
a bond, its price will go up and you can sell
it for a profit. Okay, our last core source.
Real estate and royalties. This feels like the
oldest form of passive wealth. It really is.
And this takes us back to that 1930s concept
you mentioned from our sources, from the economist
J .A. Hobson. He coined the term improperty.
Improperty. That's a great word. Isn't it? And
it wasn't just another word for property. It
was a critique. It specifically meant assets
that are owned for the sole purpose of extracting
income from other people without the owner doing
any productive work themselves. So it's not about
building something. It's about owning something
that others need. Exactly. The classic examples
of improperty are land and housing, where the
owner extracts rent from tenants, or things like
patents and copyrights, where the owner extracts
a royalty payment for the use of their intellectual
property. Both provide a steady income stream
and often have fantastic potential for the underlying
asset to appreciate in value over time. And the
big advantage here, compared to stocks and bonds,
is control. Total control. If you own a stock,
you have basically no say in how the company
is run. If you own a rental property, you decide
everything. The rent, the upgrades, who you rent
to. But that control comes with a huge, huge
downside. The cost of entry is massive. Buying
an investment property can cost hundreds of thousands
or millions of dollars. The initial investment
for a down payment, closing costs, and getting
the place ready is just astronomical compared
to buying a single share of an ETF. But for people
who want the benefits of real estate without
having to buy a whole building, there's a more
modern option now, right? Yes, real estate crowdfunding.
These are online platforms that let a bunch of
smaller investors pool their money together to
invest in a big project. like a new apartment
building or a shopping center. So it democratizes
access. It does. You can get in for maybe a few
thousand dollars. Yeah. And you get the benefits,
your share of the rental income, your share of
the appreciation, without having to manage the
property yourself. It allows you to be a truly
passive real estate investor. Okay, this is a
perfect pivot point. We've talked about financial
definitions, economic ideas. Now it's time to
get into the weeds. For our listeners in the
U .S., this is the most important part of the
conversation. how the Internal Revenue Service
sees all of this. This is where things get complicated
and where the definition of passive income becomes
incredibly specific and, frankly, counterintuitive.
The IRS, as we mentioned, has three main buckets
for income, active, passive, and portfolio. And
that distinction between passive and portfolio
is the one that trips up 99 % of people. So laid
out for us. What to the IRS is actually passive
income? It is an extremely narrow definition.
According to the IRS, passive income comes from
only two and only two types of passive activities.
The first is rental activity. The second is trade
or business activities in which you do not materially
participate. That's it. That's it. Which means.
All that interest you earn from your savings
account, all those dividends you get from your
index fund, that is not passive income to the
IRS. That is portfolio income. That is, I think,
the single most important clarification we can
make. A million dollars in dividends is portfolio.
A million dollars from a passively managed apartment
complex is passive activity income. Why does
the IRS care so much about this distinction?
It all comes down to losses, specifically the
passive activity loss rules. OK. The general
rule is that you can only use losses. from a
passive activity to offset income from other
passive activities. You can't, for example, use
a big loss from your rental property to reduce
the taxable income from your high paying doctor
salary. Ah, I see. It's a firewall. It's a firewall.
If the IRS didn't make this rigid distinction,
you can imagine what would happen. Wealthy individuals
could buy up real estate, generate huge paper
losses through things like depreciation, and
then use those passive losses to wipe out all
the taxes on their high -tax portfolio income
from stocks and bonds. This rule prevents that.
OK, that makes sense. So let's dig into those
two categories. First, the trade or business
where you don't materially participate. We keep
using that phrase. How does the IRS actually
measure material participation? They measure
it with what are known as the seven material
participation tests. The burden is on you, the
taxpayer, to prove you meet one of these tests
if you want your income to be considered active.
Let's go through the big ones. The biggest, the
clearest is quantitative. It's the 500 hour rule.
If you participate in the activity for more than
500 hours during the tax year period, you are
materially participating. The income is active.
So if I own a little bookstore and I'm there
working 10 hours a week every week, I've cleared
the 500 -hour rule. It's active income. Absolutely.
No question. But what if it's a very small business?
Maybe it only requires a couple hours a week
total. That brings us to the second test, substantially
all participation. If your participation makes
up... well, substantially, all of the participation
from everyone involved, including people who
aren't owners, then you materially participate.
So if I have a little side business selling things
online and I only spend 80 hours on it all year,
but my spouse or an employee doesn't do anything,
I'm still the one doing all the work. You're
doing all the work, so it's active. This prevents
someone from claiming their income is passive
just because the business is small. There are
other tests, too, like the significant participation
activity rule, which is a bit complex, but it
basically looks at your total time across several
different activities. And there are look back
rules like the five out of 10 rule, which says
if you materially participated in five of the
last 10 years, you're still considered active.
It's pretty clear they've built a very high,
very dense fence. To stop people from just, you
know, showing up for an hour awake and calling
their business income passive. An extremely dense
fence, yes. Okay, let's move to the other big
category of passive activity, rental activities.
This seems more straightforward, but the sources
say there are some major exceptions. Right, the
basic definition is an activity where people
pay you to use your tangible property. There
are four key situations where your rental is
not considered a passive activity, even if you're
not personally involved. And the first one feels
like it was written specifically for the age
of Airbnb, the seven -day rule. The seven -day
rule. If the average period a customer uses your
property is seven days or less, it is not a rental
activity in the eyes of the IRS. So short -term
rentals? Vacation rentals? They're not passive
rental activities. The IRS views that as running
a hospitality business, which is an active trader
business. It's more like a hotel than a long
-term lease. The constant turnover of guests
requires a level of management that pushes it
into the active category, regardless of whether
you hire a company to do the cleaning. That's
a huge distinction. So if my average guest stays
for six days, I'm running a business. If my average
guest stays for eight days, I might have a passive
rental. Wow. Okay, what if the stay is a little
longer? That takes us to exception number two,
the 30 -day rule. If the average stay is 30 days
or less, and you provide significant personal
services to the guests. What counts as significant
personal services? This is where it gets really
granular. Let's say you're renting out furnished
corporate apartments for three -week stays. If
you also provide daily cleaning, a concierge
service, maybe you stock the fridge. Those are
significant personal services. That makes it
an active business. But what if I just, you know,
have the common areas of my apartment building
cleaned once a week? Or I send a plumber when
a pipe bursts? The IRS is very clear on this.
That does not count. Routine maintenance, repairs,
cleaning common areas. Those are considered standard
custodial duties of a landlord, not significant
personal services. The service has to be specific
and substantial to that customer's stay. So the
difference between a passive rental and an active
business can literally come down to how often
you change the towels. It absolutely can. The
other two exceptions are a bit more niche. One
is for extraordinary personal services. Think
of a hospital or a boarding school. You're paying
for the medical care or the education. The room
is just... incidental. The other is if the rental
is just a tiny part of a larger investment strategy,
like you're holding land mainly for appreciation
and you rent a tiny piece of it for a cell tower.
Okay, let's look at the second main type of passive
activity again, trade or business. We talked
about the silent partner. Right. A trade or business
activity is just running any kind of business.
The way it becomes passive is through your non
-participation. The classic example is a limited
partner. You provide the capital for a new restaurant,
you get a share of the profits, but you have
zero role in the daily operations. You don't
hire staff, you don't choose the menu. You don't
meet any of those seven material participation
tests. You don't come close. So your share of
the profits is classic passive income under the
IRS definition. Okay, two final very technical
U .S. classifications from our sources. First,
royalties. When are they passive? This is another
tricky one. The IRS says royalties are passive.
only when they are not derived in the ordinary
course of a trade or business. What does that
mean? It means if you are a professional musician
who writes and actively promotes your music,
the royalties you get are active business income.
But if you, say, inherit the patent for your
great uncle's invention from the 1970s and you
just get a check from a company that licenses
it, that's passive. You're not in the business
of inventing. You're just a passive owner of
the asset. And finally, something called self
-charged interest. This sounds incredibly technical.
It is, and it's designed to fix a very specific
potential tax problem. Self -charged interest
can be treated as passive income if the loan
proceeds are used in a passive activity. Give
me an example. Okay. Say you personally own LLC,
and that LLC owns a rental property, which is
a passive activity. The LLC needs cash for a
new roof, so you personally lend $20 ,000 to
your own LLC. So I'm both the lender and, through
my company, the borrower. Exactly. Now, the LLC
pays you interest. Normally, that interest you
receive would be portfolio income. Meanwhile,
the interest the LLC pays is a passive activity
expense. You see the mismatch. Yeah, I'd have
portfolio income, which is taxed, and a passive
loss, which I might not be able to use. Precisely.
The self -charged interest rule allows you to
recharacterize some of that portfolio interest
income as passive income, so you can offset it
with the passive interest expense. It's a fairness
mechanism for when you transact with your own
passive entity. The level of detail here just
proves that this whole U .S. system is built
to prevent people from gaming the rules. And
yet the reality, according to our notes, is that
only about 20 percent of Americans get any passive
income at all. And for most of them, it's a tiny
amount, less than $5 ,000 a year, mostly from
a little bit of interest, some small dividends
or maybe getting rent from a roommate. The overwhelming
majority of people are earning active income,
which takes us right back to that wage tax critique.
It really does. OK, that deep dive into the US
system is fascinating and it shows just how much
the tax code shapes the definition. So let's
zoom out. How do other major countries handle
this? It's a great question because the US complexity
really highlights what happens when a tax authority
gets granular. Other places are different and
some don't even really try to define it at all.
Let's start with Europe. Is there a single EU
-wide definition? Not at all. There's no single
word or formal definition for passive income
from the European Commission. Taxation is still
a power held by the individual member states.
So the rules for taxing, say, rental income in
Spain, are completely different from the rules
in Sweden. It creates a lot of complexity for
anyone investing across the continent. But there
is some international guidance, right, from the
OECD. Yes, and this is very important. The OECD's
Common Reporting Standard, or CRS, is a global
framework designed to get countries to automatically
share financial information with each other.
To stop tax evasion. Primarily, yes. Now, the
CRS doesn't formally define passive income either.
But it gives a guiding list to all the signatory
countries of what kind of income they should
be looking for. And that list includes things
like dividends, interest, non -active rents and
royalties, annuities, and gains from selling
financial assets. So it's a much broader source
-based list than the IRS's narrow activity -based
one. Exactly. The IRS is basically saying if
the income is coming from capital, not labor.
We need to be tracking it. It's all about preventing
people from hiding their investment profits in
a low tax country without reporting it back home.
OK, now let's go to China, because this is where
that tension we talked about taxing capital versus
taxing labor gets really dramatic. China is one
of the most interesting examples in our material.
China has a proportional or flat tax rate of
20 percent for passive and unearned income, especially
capital gains. A flat 20 percent tax on investment
profits. A flat 20 percent. Now, compare that
to their tax on active income on wages and salaries.
That's on a steeply progressive scale. It goes
all the way up to 45 % for the highest earners.
Wow. So the incentive is incredibly clear. It's
massive. And the sources we have highlight the
intense debate around this. Proponents will say
that a low, flat tax on capital is good for the
economy. It encourages investment, it attracts
foreign capital, and it keeps wealthy people
from just hiding their money. It's an efficiency
argument. But the argument against it from an
equity standpoint must be huge. It's the core
of the critique. Yeah. Critics argue this system
is fundamentally, or as they say, horizontally
unfair. If a top surgeon earns a million dollars
through her labor, she could pay a marginal rate
near 45 percent. If an investor makes a million
dollars by selling stock, he pays only 20 percent.
That's a massive difference. It is. And the analysis
in our sources suggests this structure fails
to regulate the income distribution gap in China.
In fact, it actively makes it worse by dramatically
favoring wealth derived from ownership over wealth
derived from effort. It's a real world example
of that wage tax idea in action. Let's look at
a couple of other specific examples. Russia and
Kazakhstan have interesting approaches to securities.
They do. Russia's system is all about the principle
of realization. They have a 13 % tax on investment
income, but it only applies when the income is
actually realized. Meaning when it turns into
cash. Exactly. When you sell the stock for a
profit or when you receive a cash dividend or
a bond coupon. So if you buy a Russian stock
and its value on paper doubles, but you don't
sell it. You pay zero tax. No tax on unrealized
gains. None. The tax event only happens when
you liquidate. And it's worth noting that for
non -residents, the tax on dividends from Russian
companies is a bit higher, at 15%. But what about
Kazakhstan? They seem to use their tax policy
to encourage local investment. They do. It's
a very targeted incentive. They have a low 5
% income tax on dividends. But here's the key.
That dividend income... And any income from the
stock's value increasing is completely tax exempt
if the stock is on the official list of the local
Kazakhstani stock exchanges. So it's a huge tax
break, but only if you invest in Kazakhstani
companies trading on local markets. Right. It's
a clear policy choice designed to keep capital
within the country and to bolster their domestic
stock market. So if we bring it back to the U
.S. one last time, just to frame all this, we
have the three narrow IRS buckets, active, passive,
portfolio, which are all about setting tax rules.
But the sources mention the tax code also uses
four broader categories to just define gross
income. That's right. And it's a useful final
clarification. Those four broad source categories
are just a list. They are, one, income from labor,
like wages. Two, income from capital, like dividends
and interest. Three, income from transfer, like
winning a prize or getting unemployment benefits.
And four, a weird one called presumptive income,
which covers things like below -market loans.
And these are just to make sure all money is
accounted for. They don't set the tax rates.
Correct. They're just a checklist to define what
counts as income in the first place. All the
real policy work, the different tax rates, the
loss rules, the credits. That all happens when
the IRS applies those much narrower, much more
complex definitions of active, passive and portfolio.
It really confirms that this whole debate is
less about the general idea of work and more
about very specific legal rules written to define
the value of capital versus the value of labor.
a perfect place to wrap up our deep dive so we've
gone on quite a journey today we started with
this you know, glossy promise of easy wealth.
And we've ended up deep in the technical guts
of global tax codes. We certainly have. And I
think the most crucial takeaway for you, the
listener, is that passive income isn't just a
simple catchphrase. It's a highly technical,
legally defined concept. And that definition
can change dramatically depending on whether
you're talking to your financial planner about
your retirement goals or to your accountant about
your tax liability. That's the key. What an investor
calls passive and what the IRS calls passive
can be two totally different things. Absolutely.
The stock dividends that everyone thinks of as
passive, the IRS calls that portfolio income.
And it's not just semantics. It has huge implications
for how your losses are treated and how your
income is taxed. For me, the thing that really
stands out, the surprising fact that proves how
technical this gets, is that IRS scrutiny of
rental activities. That seven -day rule. The
idea that if you rent your place out for an average
of six days, it's an active business. But if
you rent it out for an average of eight days,
it might be a passive activity. Or the specific
definitions of what does and doesn't count as
a significant personal service. It just shows
that the difference between two completely different
tax treatments can come down to whether you offer
a daily turndown service. It's that granular.
And that kind of detail shows you the complex
guardrails that are required to draw a line between
capital and labor in our economy. And that leads
us to our final provocative thought for you to
consider. Based on everything we've discussed,
we've seen a clear global trend, right, in the
U .S. with how portfolio income is taxed and
very sharply in China with their flat capital
gains tax versus their progressive wage tax.
The trend is that income from owning capital
is generally taxed at a lower, often proportional
rate. while income from active labor is taxed
at higher progressive rates. The wage tax. The
wage tax. So the question to leave you with is
this. What is the long -term impact of that policy
choice on our very definition of effort in achieving
wealth? And more fundamentally, how might our
tax codes, both here and around the world, need
to evolve if they want to address this growing
horizontal inequity between those who earn money
with their time and those who earn it with their
capital?