WEBVTT 00:00:00.000 --> 00:00:02.180 Welcome back to the Deep Dive. Today, we're taking 00:00:02.180 --> 00:00:04.660 on a term you've definitely heard before, probably 00:00:04.660 --> 00:00:06.740 a thousand times if you spend any time online, 00:00:06.940 --> 00:00:09.580 passive income. Oh, absolutely. It's everywhere. 00:00:09.800 --> 00:00:12.179 It is. It's sold to us as this golden ticket, 00:00:12.359 --> 00:00:14.359 right? The shortcut to financial freedom. Yeah. 00:00:14.439 --> 00:00:16.820 You see these images of people on a beach with 00:00:16.820 --> 00:00:20.179 their laptop. And the idea is money is just. 00:00:20.859 --> 00:00:23.280 flowing into their account while they're, I don't 00:00:23.280 --> 00:00:25.780 know, hiking in Peru. It's a powerful marketing 00:00:25.780 --> 00:00:27.800 hook. I mean, who doesn't want to separate their 00:00:27.800 --> 00:00:29.859 labor from their livelihood? That's the dream. 00:00:30.019 --> 00:00:32.679 But that dream, that marketing hype, it runs 00:00:32.679 --> 00:00:34.700 into a brick wall. The brick wall of reality. 00:00:35.100 --> 00:00:38.700 The brick wall of your accountant and, more importantly, 00:00:38.840 --> 00:00:41.659 the tax authorities. So our mission today is 00:00:41.659 --> 00:00:43.700 to really cut through all that noise. We're going 00:00:43.700 --> 00:00:46.619 to dive into the precise, the technical, and 00:00:46.619 --> 00:00:49.320 frankly, the often extremely narrow definitions 00:00:49.320 --> 00:00:51.829 of passive. of income. Especially how governments 00:00:51.829 --> 00:00:54.289 like the IRS here in the U .S. actually see it. 00:00:54.350 --> 00:00:57.189 We're separating the beach fantasy from what 00:00:57.189 --> 00:00:58.850 you actually put on your tax forms. Exactly. 00:00:58.950 --> 00:01:02.770 From the Instagram post to, say, Form 8582. OK, 00:01:02.869 --> 00:01:05.049 so let's build this from the ground up. Our sources 00:01:05.049 --> 00:01:09.370 for this are pretty technical. We're not giving 00:01:09.370 --> 00:01:11.409 out investment tips today. We're trying to understand 00:01:11.409 --> 00:01:13.969 how the system actually defines the money you 00:01:13.969 --> 00:01:17.319 earn. Right. And to do that. we have to start 00:01:17.319 --> 00:01:19.840 with the most fundamental technical definition 00:01:19.840 --> 00:01:23.760 from the material we have. Officially, passive 00:01:23.760 --> 00:01:26.959 income is a type of unearned income. Unearned. 00:01:26.959 --> 00:01:29.579 That sounds a little negative. It's just a technical 00:01:29.579 --> 00:01:32.340 term. It means the income is acquired with, and 00:01:32.340 --> 00:01:35.659 this is the key phrase, little to no labor to 00:01:35.659 --> 00:01:38.989 earn or maintain it. And that's... after the 00:01:38.989 --> 00:01:41.230 initial asset is in place. After the asset is 00:01:41.230 --> 00:01:43.269 set up, that's an important distinction. A critical 00:01:43.269 --> 00:01:44.950 one. It's usually combined with your regular 00:01:44.950 --> 00:01:47.590 job, your salary. But the single most defining 00:01:47.590 --> 00:01:50.590 feature is that you, the beneficiary, get this 00:01:50.590 --> 00:01:53.609 income regardless of your ongoing material activity 00:01:53.609 --> 00:01:56.049 in whatever is creating the revenue. And that's 00:01:56.049 --> 00:01:58.010 the whole point, right? That separation between 00:01:58.010 --> 00:02:00.569 your personal time and your personal revenue. 00:02:00.790 --> 00:02:02.829 It's what makes it the holy grail for the whole 00:02:02.829 --> 00:02:05.010 FIRE movement. Financial independents retire 00:02:05.010 --> 00:02:07.719 early. Absolutely. If you're passive, income 00:02:07.719 --> 00:02:10.300 streams cover your monthly expenses, your monthly 00:02:10.300 --> 00:02:13.400 nut, you are by definition financially independent. 00:02:13.919 --> 00:02:16.719 It cuts the cord. So it's really about owning 00:02:16.719 --> 00:02:19.599 capital, not selling your time. Precisely. At 00:02:19.599 --> 00:02:22.219 its highest level, that's what it is. It's about 00:02:22.219 --> 00:02:25.050 leveraging ownership. OK, so our source material 00:02:25.050 --> 00:02:29.009 lays out the big classic examples. I see three 00:02:29.009 --> 00:02:31.550 main buckets here. First is owning financial 00:02:31.550 --> 00:02:34.430 assets like an index fund that pays out dividends. 00:02:34.449 --> 00:02:37.270 The classic portfolio stuff, yes. Second, rental 00:02:37.270 --> 00:02:39.509 income, you know, owning a property and having 00:02:39.509 --> 00:02:42.110 tenants. And third, and this one's a bit more 00:02:42.110 --> 00:02:45.069 vague, it's profits from a business where the 00:02:45.069 --> 00:02:48.310 owner does not materially participate. The silent 00:02:48.310 --> 00:02:50.800 partner. You put in the money. but you're not 00:02:50.800 --> 00:02:53.060 running the day -to -day operations. And this 00:02:53.060 --> 00:02:55.180 income, it doesn't always look like a regular 00:02:55.180 --> 00:02:57.340 paycheck, does it? The sources say it can come 00:02:57.340 --> 00:02:59.539 in different forms. Right. It can be a big lump 00:02:59.539 --> 00:03:02.180 sum. Think about an inheritance. Or maybe you 00:03:02.180 --> 00:03:04.539 sell a piece of property that's appreciated massively 00:03:04.539 --> 00:03:07.780 over 20 years. That's a huge injection of passive 00:03:07.780 --> 00:03:11.139 capital. Or it can be a steady stream. Or it 00:03:11.139 --> 00:03:14.060 can be a stream, paid out over time. And this 00:03:14.060 --> 00:03:16.159 is where it gets kind of wild. Our sources point 00:03:16.159 --> 00:03:18.139 out this stream can potentially last for centuries, 00:03:18.280 --> 00:03:21.460 across generations. Centuries? Think about it. 00:03:21.479 --> 00:03:24.259 A huge portfolio of dividend -paying stocks, 00:03:24.460 --> 00:03:26.979 or a well -located piece of real estate in a 00:03:26.979 --> 00:03:29.840 major city, or even certain kinds of debt instruments. 00:03:30.419 --> 00:03:32.960 These assets can just keep generating income 00:03:32.960 --> 00:03:36.020 indefinitely. It basically makes a family wealthy 00:03:36.020 --> 00:03:39.319 just for the act of owning the capital that generates 00:03:39.319 --> 00:03:43.009 the return. That idea of income lasting for centuries, 00:03:43.210 --> 00:03:45.849 that leads directly to the big critique of this 00:03:45.849 --> 00:03:48.150 whole structure, which you flagged in our prep. 00:03:48.370 --> 00:03:50.370 It really does, because this is where the politics 00:03:50.370 --> 00:03:52.509 and the economics of it get very, very real. 00:03:52.810 --> 00:03:55.449 The source material we have highlights this major 00:03:55.449 --> 00:03:57.969 critique. Passive income structures are often 00:03:57.969 --> 00:04:01.610 used as, let's be blunt, sophisticated tax avoidance 00:04:01.610 --> 00:04:03.750 schemes. Mostly by people who can afford the 00:04:03.750 --> 00:04:05.870 lawyers and accountants to set them up. Exactly. 00:04:05.990 --> 00:04:08.009 High net worth individuals who can structure 00:04:08.009 --> 00:04:10.680 their income so it qualifies. capital gains or 00:04:10.680 --> 00:04:12.919 these specific passive activities, which are 00:04:12.919 --> 00:04:15.280 often taxed at a much lower rate than the salary 00:04:15.280 --> 00:04:17.459 you earn from your job. And that gets to the 00:04:17.459 --> 00:04:20.399 fairness of the whole tax system. It's the absolute 00:04:20.399 --> 00:04:23.439 heart of the debate. The critics argue that because 00:04:23.439 --> 00:04:25.759 this capital -based income can avoid the highest 00:04:25.759 --> 00:04:28.519 tax brackets, the personal income tax itself 00:04:28.519 --> 00:04:32.860 has been, well... They argue it's basically become 00:04:32.860 --> 00:04:36.019 a wage tax. A wage tax. A tax aimed almost exclusively 00:04:36.019 --> 00:04:38.819 at the middle and upper middle working class, 00:04:38.980 --> 00:04:41.579 people whose wealth comes from their salaries, 00:04:41.680 --> 00:04:44.399 their wages, their bonuses, all of which are 00:04:44.399 --> 00:04:46.519 subject to those higher progressive tax rates. 00:04:46.920 --> 00:04:49.339 Capital gets a discount. Labor pays the full 00:04:49.339 --> 00:04:52.100 price. We're going to see this theme pop up again 00:04:52.100 --> 00:04:54.040 and again, especially when we look at different 00:04:54.040 --> 00:04:56.819 countries. That's a powerful framework. So with 00:04:56.819 --> 00:04:59.079 that critique in mind, let's start breaking down 00:04:59.079 --> 00:05:01.259 the different types of income. To understand 00:05:01.259 --> 00:05:03.740 what's passive, we first have to understand what 00:05:03.740 --> 00:05:06.360 it's not. Right. Let's start with its polar opposite, 00:05:06.579 --> 00:05:08.980 active income. The one we're all very familiar 00:05:08.980 --> 00:05:11.279 with. The one most people live on, yes. Active 00:05:11.279 --> 00:05:14.220 income is, simply put, income you get from performing 00:05:14.220 --> 00:05:16.420 a service. It's trading your time and your skills 00:05:16.420 --> 00:05:20.139 for money. So your salary, your wages, tips if 00:05:20.139 --> 00:05:23.550 you're a server, bonuses. All of that. And importantly, 00:05:23.790 --> 00:05:26.110 self -employment income. If you're a freelance 00:05:26.110 --> 00:05:28.509 writer, a consultant, a plumber, that's active 00:05:28.509 --> 00:05:31.790 income. It also includes any money you get from 00:05:31.790 --> 00:05:34.810 a partnership or an S corporation if you materially 00:05:34.810 --> 00:05:36.870 participate in the business. There's that phrase 00:05:36.870 --> 00:05:39.810 again, materially participate. So let's use your 00:05:39.810 --> 00:05:42.110 plumber example. If I start a plumbing business 00:05:42.110 --> 00:05:44.649 and I'm the one showing up to houses, fixing 00:05:44.649 --> 00:05:48.079 leaks every day. That's my active intent. Literally 00:05:48.079 --> 00:05:50.680 active, yes. But if I just invest in my friend's 00:05:50.680 --> 00:05:53.040 plumbing business, I give her the startup capital, 00:05:53.120 --> 00:05:55.339 and I just get a check every quarter without 00:05:55.339 --> 00:05:57.860 ever touching a wrench, that's leaning passive. 00:05:58.319 --> 00:06:01.180 Exactly. The entire distinction hinges on that 00:06:01.180 --> 00:06:04.600 one concept, material participation. The income 00:06:04.600 --> 00:06:06.620 is active if you meet the requirements, which, 00:06:06.699 --> 00:06:08.800 as we'll see later, are often based mainly on 00:06:08.800 --> 00:06:10.899 the number of hours you work. If you're involved 00:06:10.899 --> 00:06:13.000 in management and daily operations and the big 00:06:13.000 --> 00:06:15.790 decisions, you're active. If you're just a checkbook, 00:06:15.889 --> 00:06:18.910 you're passive. Okay. So that's the active pull. 00:06:19.490 --> 00:06:21.850 Now, what about the category that gets confused 00:06:21.850 --> 00:06:24.649 with passive income all the time? Portfolio income. 00:06:24.970 --> 00:06:28.069 Right. And it's an easy mistake to make. Portfolio 00:06:28.069 --> 00:06:30.970 income feels passive. It's the purest form of 00:06:30.970 --> 00:06:33.110 your money working for you. It comes strictly 00:06:33.110 --> 00:06:35.509 from holding financial assets. Dividends from 00:06:35.509 --> 00:06:37.850 stocks, interest from a savings account, or a 00:06:37.850 --> 00:06:40.129 bond. Capital gains when you sell a stock for 00:06:40.129 --> 00:06:42.529 more than you paid. and in some cases, certain 00:06:42.529 --> 00:06:45.029 kinds of royalties. It's all income from capital, 00:06:45.110 --> 00:06:47.670 not labor. But here's the first big technical 00:06:47.670 --> 00:06:50.850 trap, especially for our U .S. listeners. A financial 00:06:50.850 --> 00:06:53.069 advisor might tell you your dividend checks are 00:06:53.069 --> 00:06:57.089 passive income, but the IRS sees it very differently. 00:06:57.089 --> 00:06:59.490 Very differently. This is probably the most important 00:06:59.490 --> 00:07:02.069 distinction we'll make today. The U .S. tax code 00:07:02.069 --> 00:07:05.449 has a super narrow category called passive activities. 00:07:06.149 --> 00:07:08.790 Portfolio income, your dividends, your interest, 00:07:08.949 --> 00:07:12.129 your capital gains is not in that category. It's 00:07:12.129 --> 00:07:15.199 in its own bucket. Its own separate bucket. And 00:07:15.199 --> 00:07:17.379 this matters immensely because in the U .S., 00:07:17.379 --> 00:07:19.759 portfolio income often gets preferential tax 00:07:19.759 --> 00:07:22.600 treatment. Long -term capital gains and qualified 00:07:22.600 --> 00:07:25.279 dividends are taxed at much lower rates than 00:07:25.279 --> 00:07:27.439 your salary. Which brings us right back to that 00:07:27.439 --> 00:07:30.259 wage tax critique. It's the mechanism for it. 00:07:30.360 --> 00:07:33.439 The tax code explicitly creates a financial incentive 00:07:33.439 --> 00:07:37.540 to earn money from capital portfolio income over 00:07:37.540 --> 00:07:40.579 earning it from labor or active income. Okay, 00:07:40.620 --> 00:07:42.629 now let's tackle the new kid on the block. The 00:07:42.629 --> 00:07:44.250 one that all the online influencers are talking 00:07:44.250 --> 00:07:47.480 about, this idea of leveraged income. Yes. The 00:07:47.480 --> 00:07:49.819 e -book, the online course, the software tool. 00:07:50.360 --> 00:07:53.420 Leveraged income, as our sources define it, is 00:07:53.420 --> 00:07:56.300 when you invest your labor once to create an 00:07:56.300 --> 00:07:58.680 asset that can then be sold over and over again. 00:07:58.759 --> 00:08:01.100 So the work is all up front. Exactly. The work 00:08:01.100 --> 00:08:03.779 is front -loaded into creating a scalable product. 00:08:04.100 --> 00:08:07.180 You might spend, say, 500 hours writing and filming 00:08:07.180 --> 00:08:09.759 a professional video course. That's a huge amount 00:08:09.759 --> 00:08:12.240 of active, difficult work. No question. That 00:08:12.240 --> 00:08:15.439 is not passive. Not at all. It's a grind. Once 00:08:15.439 --> 00:08:17.639 that course is uploaded and the sales funnel 00:08:17.639 --> 00:08:20.600 is built, the revenue can, in theory, flow in 00:08:20.600 --> 00:08:22.839 with minimal ongoing effort. You might answer 00:08:22.839 --> 00:08:24.740 a few emails, maybe update a video once a year. 00:08:24.860 --> 00:08:27.160 But the income stream is effectively decoupled 00:08:27.160 --> 00:08:29.540 from the time you spend generating each new sale. 00:08:29.720 --> 00:08:31.720 So is it passive? It feels like it breaks the 00:08:31.720 --> 00:08:34.600 definition. It's a hybrid. It's a fascinating 00:08:34.600 --> 00:08:38.039 modern creation. It requires a ton of active 00:08:38.039 --> 00:08:41.340 labor to earn the asset. But the money it generates 00:08:41.340 --> 00:08:44.120 afterward behaves a lot like passive income. 00:08:44.960 --> 00:08:47.360 The key thing for, you know, that e -book offer 00:08:47.360 --> 00:08:49.820 to remember is that while the income might feel 00:08:49.820 --> 00:08:52.340 passive, the tax authority is probably going 00:08:52.340 --> 00:08:55.679 to view the initial money from it as being fundamentally 00:08:55.679 --> 00:08:58.740 tied to your labor. It really disrupts that old 00:08:58.740 --> 00:09:01.460 school capital versus labor split. That distinction 00:09:01.460 --> 00:09:03.860 is so important. It reminds you that passive 00:09:03.860 --> 00:09:06.120 doesn't mean the money just appeared from nowhere. 00:09:06.360 --> 00:09:08.779 It just means the person receiving the check 00:09:08.779 --> 00:09:11.480 wasn't the one who performed the final piece 00:09:11.480 --> 00:09:15.970 of labor that generated it. The stockholder getting 00:09:15.970 --> 00:09:18.990 a dividend. Exactly. Take some giant multinational 00:09:18.990 --> 00:09:22.110 company. You own a few shares. When you get your 00:09:22.110 --> 00:09:24.789 quarterly dividend, that action is completely 00:09:24.789 --> 00:09:26.809 passive for you. You did nothing but own the 00:09:26.809 --> 00:09:29.850 stock. But that dividend was only possible because 00:09:29.850 --> 00:09:33.250 of the constant active work of tens of thousands 00:09:33.250 --> 00:09:35.570 of employees. The people on the factory floor, 00:09:35.730 --> 00:09:38.210 the sales team, the engineers, they're all earning 00:09:38.210 --> 00:09:41.070 active income for their labor. The passivity 00:09:41.070 --> 00:09:43.549 is just a function of your position on the balance 00:09:43.549 --> 00:09:46.320 sheet. You're an owner of capital, not a seller 00:09:46.320 --> 00:09:49.179 of labor. OK, let's circle back to rental income, 00:09:49.259 --> 00:09:51.080 because I think for a lot of people, that's the 00:09:51.080 --> 00:09:53.220 one that feels the least passive in the real 00:09:53.220 --> 00:09:55.820 world. You own a duplex, you get the rent checks. 00:09:55.960 --> 00:09:58.059 Great. But then a tenant calls you at three in 00:09:58.059 --> 00:09:59.519 the morning because the basement's flooding. 00:10:00.019 --> 00:10:03.059 That's work. And it's often hard, stressful work. 00:10:03.200 --> 00:10:05.139 Our sources are clear that rental income does 00:10:05.139 --> 00:10:07.820 require managerial and custodial duties. That's 00:10:07.820 --> 00:10:09.879 the friction. That's what makes it feel active. 00:10:10.299 --> 00:10:12.899 But the key difference here, the thing that preserves 00:10:12.899 --> 00:10:15.960 its passive status, is the ability to outsource. 00:10:16.159 --> 00:10:18.620 You mean hiring a property manager? A property 00:10:18.620 --> 00:10:21.220 manager, a leasing agent, a handyman on call. 00:10:21.399 --> 00:10:23.700 All of those people are earning active income 00:10:23.700 --> 00:10:26.899 for their services. But if you, the owner, can 00:10:26.899 --> 00:10:29.639 pay them to handle everything, your profit stream 00:10:29.639 --> 00:10:32.519 can remain entirely passive. So the calculation 00:10:32.519 --> 00:10:34.759 for the investor is pretty simple then. It is. 00:10:34.899 --> 00:10:37.950 Does my monthly rent check cover... The mortgage, 00:10:38.190 --> 00:10:40.950 the taxes, the upkeep, and the cost of paying 00:10:40.950 --> 00:10:42.889 someone else to manage it all. If the answer 00:10:42.889 --> 00:10:44.950 is yes, you have a passive income stream. And 00:10:44.950 --> 00:10:47.129 if you have to manage it yourself just to break 00:10:47.129 --> 00:10:49.269 even... Then you're spending significant time 00:10:49.269 --> 00:10:52.049 on it, and the IRS is going to look at that much, 00:10:52.049 --> 00:10:54.629 much more closely. Outsourcing the management 00:10:54.629 --> 00:10:57.750 is the key to true passivity in real estate. 00:10:57.970 --> 00:11:00.590 This feels like a good place to transition. We've 00:11:00.590 --> 00:11:03.009 defined the landscape active portfolio, that 00:11:03.009 --> 00:11:05.129 leveraged hybrid, and the technical definition 00:11:05.129 --> 00:11:07.629 of passive. Now let's get into the practical 00:11:07.629 --> 00:11:10.830 applications, the four core sources for building 00:11:10.830 --> 00:11:13.029 this kind of capital -based income. Right. Let's 00:11:13.029 --> 00:11:14.970 move from the definitions to the actual assets, 00:11:15.230 --> 00:11:17.870 comparing the risks and rewards. And let's start 00:11:17.870 --> 00:11:20.330 at the absolute bottom of the risk ladder, deposits. 00:11:20.950 --> 00:11:24.429 Safe, stable, but maybe not that exciting. Not 00:11:24.429 --> 00:11:27.090 at all exciting, but foundational. For a lot 00:11:27.090 --> 00:11:29.389 of people, this is their first and only source 00:11:29.389 --> 00:11:31.909 of passive income, the interest they earn from 00:11:31.909 --> 00:11:34.590 a high -yield savings account. You put your money 00:11:34.590 --> 00:11:37.049 in the bank, and the bank pays you a small amount 00:11:37.049 --> 00:11:39.870 of interest each period. It's simple, it's liquid, 00:11:40.009 --> 00:11:42.690 and it's usually insured up to a certain amount. 00:11:43.549 --> 00:11:46.370 Very low risk. And a step up from that, still 00:11:46.370 --> 00:11:49.009 in the safe zone, are certificates of deposit 00:11:49.009 --> 00:11:52.639 or CDs. Right. CDs are a commitment. You agree 00:11:52.639 --> 00:11:55.200 to give the bank a fixed amount of money for 00:11:55.200 --> 00:11:57.279 a fixed period of time. It could be six months. 00:11:57.340 --> 00:11:59.879 It could be five years. And in exchange for locking 00:11:59.879 --> 00:12:01.799 up your money, you get a better interest rate, 00:12:01.879 --> 00:12:04.200 usually a much better rate than a standard savings 00:12:04.200 --> 00:12:06.340 account. They're great for capital preservation. 00:12:06.980 --> 00:12:08.919 If you have money you absolutely cannot afford 00:12:08.919 --> 00:12:11.299 to lose, but you want it to earn a little more 00:12:11.299 --> 00:12:13.559 than it would in a checking account, a CD is 00:12:13.559 --> 00:12:15.919 a solid choice. But they are very strict about 00:12:15.919 --> 00:12:18.639 that time commitment. Oh, yeah. Try to pull your 00:12:18.639 --> 00:12:20.559 money out early, and you'll get hit with a... 00:12:20.750 --> 00:12:23.490 pretty significant penalty. The whole model is 00:12:23.490 --> 00:12:26.110 based on them having your capital for that guaranteed 00:12:26.110 --> 00:12:29.610 period. And the formula is simple. The more money 00:12:29.610 --> 00:12:31.850 you put in and the longer you commit to leaving 00:12:31.850 --> 00:12:34.190 it there, the higher the interest rate they'll 00:12:34.190 --> 00:12:37.350 offer you. So the verdict on deposits is they're 00:12:37.350 --> 00:12:40.350 a great low -risk anchor for your finances, but 00:12:40.350 --> 00:12:41.870 you're not going to get rich off of them. The 00:12:41.870 --> 00:12:44.250 opportunity cost is high. Precisely. You're trading 00:12:44.250 --> 00:12:46.909 growth potential for safety and stability. Okay, 00:12:46.950 --> 00:12:49.509 let's climb that risk and reward ladder. Next 00:12:49.509 --> 00:12:53.110 up. stocks. This is the main engine for wealth 00:12:53.110 --> 00:12:55.850 growth for most investors. For sure. Stocks are 00:12:55.850 --> 00:12:58.429 where you can really see portfolio based passive 00:12:58.429 --> 00:13:01.629 income take off. And you make money in two ways 00:13:01.629 --> 00:13:04.980 here. The first is. Value growth or capital appreciation. 00:13:05.419 --> 00:13:08.059 You buy a share for $100, the company does well, 00:13:08.179 --> 00:13:11.419 and now it's worth $150. And the second way is 00:13:11.419 --> 00:13:13.659 dividends. Right. Dividends are when a company 00:13:13.659 --> 00:13:15.840 takes a portion of its profits and distributes 00:13:15.840 --> 00:13:17.779 it directly to shareholders. That's a cash payment, 00:13:17.879 --> 00:13:20.039 usually every quarter, that you get just for 00:13:20.039 --> 00:13:22.679 owning the stock. But investing in stocks, even 00:13:22.679 --> 00:13:26.100 a broad market index fund, is a whole different 00:13:26.100 --> 00:13:29.059 world of risk compared to a CD. A completely 00:13:29.059 --> 00:13:32.320 different universe. Stocks are volatile. Prices 00:13:32.320 --> 00:13:35.159 can swing wildly based on economic news, market 00:13:35.159 --> 00:13:38.220 sentiment, a bad earnings report. Our sources 00:13:38.220 --> 00:13:40.820 even specifically call out the risk of so -called 00:13:40.820 --> 00:13:44.000 value stocks. Why are those? They're stocks that 00:13:44.000 --> 00:13:46.559 seem undervalued by the market. They might have 00:13:46.559 --> 00:13:48.539 a lot of debt or uncertainty about their future. 00:13:49.259 --> 00:13:51.440 Investors buy them hoping for a big turnaround, 00:13:51.740 --> 00:13:53.720 but the risk of them failing is substantial. 00:13:54.200 --> 00:13:56.639 This is a game for people who are tolerant of 00:13:56.639 --> 00:13:58.639 risk, who can stomach seeing their portfolio 00:13:58.639 --> 00:14:01.899 drop 20 % and not panic. But the upside is that 00:14:01.899 --> 00:14:03.799 over the long term, stocks have historically 00:14:03.799 --> 00:14:06.919 provided returns that significantly outpace inflation. 00:14:07.220 --> 00:14:09.759 That's the tradeoff. And within stock investing, 00:14:09.940 --> 00:14:12.179 the sources highlight a really powerful passive 00:14:12.179 --> 00:14:15.679 strategy. Dividend reinvestment plans or DDPs. 00:14:15.840 --> 00:14:18.299 DDPs. How do they work? It's a beautifully simple 00:14:18.299 --> 00:14:20.740 and totally passive mechanism. Instead of the 00:14:20.740 --> 00:14:22.299 company sending you a check for your dividends, 00:14:22.460 --> 00:14:24.899 that cash is automatically used to buy more shares 00:14:24.899 --> 00:14:27.080 of that same company. So your ownership stake 00:14:27.080 --> 00:14:29.320 just keeps growing on its own. It compounds. 00:14:29.559 --> 00:14:32.080 The new shares you just bought then earn their 00:14:32.080 --> 00:14:34.860 own dividends, which then buy even more shares. 00:14:35.080 --> 00:14:38.220 Over 20 or 30 years, this process can dramatically 00:14:38.220 --> 00:14:41.320 accelerate your wealth accumulation, all without 00:14:41.320 --> 00:14:43.559 you having to lift a finger or invest a single 00:14:43.559 --> 00:14:46.139 new dollar. It's the ultimate set it and forget 00:14:46.139 --> 00:14:49.120 it strategy. OK, so we have the safety of deposits 00:14:49.120 --> 00:14:52.419 and the high risk, high reward world of stocks. 00:14:52.700 --> 00:14:54.600 What's in the middle? In the middle, we find 00:14:54.600 --> 00:14:58.299 bonds. which our sources describe as reliable 00:14:58.299 --> 00:15:01.139 debts. Reliable debts. I like that. So what is 00:15:01.139 --> 00:15:03.820 a bond fundamentally? It's just a loan. You, 00:15:03.980 --> 00:15:06.659 the investor, are lending money to a big entity. 00:15:06.779 --> 00:15:08.419 It could be the federal government, your city, 00:15:08.519 --> 00:15:11.460 or a huge corporation like Apple. That big loan 00:15:11.460 --> 00:15:13.539 is just chopped up into small tradable units. 00:15:13.659 --> 00:15:15.419 And the details of that loan are all spelled 00:15:15.419 --> 00:15:17.340 out. Everything is spelled out. There's an issue 00:15:17.340 --> 00:15:19.159 price, a face value, which is what you get back 00:15:19.159 --> 00:15:21.279 at the end. There's a coupon rate, which is the 00:15:21.279 --> 00:15:23.860 interest rate. And there's a maturity date, which 00:15:23.860 --> 00:15:26.220 is when the loan is fully repaid. So the passive 00:15:26.220 --> 00:15:28.480 income stream is that interest. It's the coupon 00:15:28.480 --> 00:15:30.960 payment. You get a fixed interest payment at 00:15:30.960 --> 00:15:34.100 regular intervals, say, every six months until 00:15:34.100 --> 00:15:37.360 the bond matures. At maturity, you get your original 00:15:37.360 --> 00:15:39.899 principal back. It's a very regular, very stable, 00:15:40.019 --> 00:15:42.419 very predictable way to build passive income. 00:15:42.740 --> 00:15:45.100 And in terms of safety, where do they fall? They 00:15:45.100 --> 00:15:47.659 are arguably the safest financial instrument 00:15:47.659 --> 00:15:50.200 you can buy. Outside of, you know, an insured 00:15:50.200 --> 00:15:52.759 bank deposit. Much less volatile than stocks. 00:15:53.100 --> 00:15:55.179 But, of course, with that safety comes lower 00:15:55.179 --> 00:15:58.019 returns. The classic risk -reward spectrum. It's 00:15:58.019 --> 00:16:00.120 always there. That's why the standard financial 00:16:00.120 --> 00:16:01.960 advice for someone trying to build a balanced 00:16:01.960 --> 00:16:05.399 portfolio is to own both stocks for growth and 00:16:05.399 --> 00:16:08.539 bonds for stability. And it's worth noting, you 00:16:08.539 --> 00:16:10.860 can sell bonds before they mature, just like 00:16:10.860 --> 00:16:13.559 stocks. If interest rates fall after you buy 00:16:13.559 --> 00:16:15.779 a bond, its price will go up and you can sell 00:16:15.779 --> 00:16:17.879 it for a profit. Okay, our last core source. 00:16:18.440 --> 00:16:20.679 Real estate and royalties. This feels like the 00:16:20.679 --> 00:16:22.879 oldest form of passive wealth. It really is. 00:16:23.120 --> 00:16:25.700 And this takes us back to that 1930s concept 00:16:25.700 --> 00:16:28.480 you mentioned from our sources, from the economist 00:16:28.480 --> 00:16:31.440 J .A. Hobson. He coined the term improperty. 00:16:32.100 --> 00:16:34.750 Improperty. That's a great word. Isn't it? And 00:16:34.750 --> 00:16:36.610 it wasn't just another word for property. It 00:16:36.610 --> 00:16:39.470 was a critique. It specifically meant assets 00:16:39.470 --> 00:16:42.049 that are owned for the sole purpose of extracting 00:16:42.049 --> 00:16:44.929 income from other people without the owner doing 00:16:44.929 --> 00:16:47.210 any productive work themselves. So it's not about 00:16:47.210 --> 00:16:49.350 building something. It's about owning something 00:16:49.350 --> 00:16:52.409 that others need. Exactly. The classic examples 00:16:52.409 --> 00:16:55.149 of improperty are land and housing, where the 00:16:55.149 --> 00:16:58.129 owner extracts rent from tenants, or things like 00:16:58.129 --> 00:17:00.629 patents and copyrights, where the owner extracts 00:17:00.629 --> 00:17:02.529 a royalty payment for the use of their intellectual 00:17:02.529 --> 00:17:05.630 property. Both provide a steady income stream 00:17:05.630 --> 00:17:08.470 and often have fantastic potential for the underlying 00:17:08.470 --> 00:17:11.970 asset to appreciate in value over time. And the 00:17:11.970 --> 00:17:14.609 big advantage here, compared to stocks and bonds, 00:17:14.809 --> 00:17:18.150 is control. Total control. If you own a stock, 00:17:18.369 --> 00:17:20.809 you have basically no say in how the company 00:17:20.809 --> 00:17:23.210 is run. If you own a rental property, you decide 00:17:23.210 --> 00:17:25.630 everything. The rent, the upgrades, who you rent 00:17:25.630 --> 00:17:28.329 to. But that control comes with a huge, huge 00:17:28.329 --> 00:17:31.930 downside. The cost of entry is massive. Buying 00:17:31.930 --> 00:17:34.210 an investment property can cost hundreds of thousands 00:17:34.210 --> 00:17:36.950 or millions of dollars. The initial investment 00:17:36.950 --> 00:17:39.529 for a down payment, closing costs, and getting 00:17:39.529 --> 00:17:42.670 the place ready is just astronomical compared 00:17:42.670 --> 00:17:45.410 to buying a single share of an ETF. But for people 00:17:45.410 --> 00:17:47.150 who want the benefits of real estate without 00:17:47.150 --> 00:17:49.089 having to buy a whole building, there's a more 00:17:49.089 --> 00:17:52.470 modern option now, right? Yes, real estate crowdfunding. 00:17:52.630 --> 00:17:55.529 These are online platforms that let a bunch of 00:17:55.529 --> 00:17:58.750 smaller investors pool their money together to 00:17:58.750 --> 00:18:00.789 invest in a big project. like a new apartment 00:18:00.789 --> 00:18:03.470 building or a shopping center. So it democratizes 00:18:03.470 --> 00:18:05.849 access. It does. You can get in for maybe a few 00:18:05.849 --> 00:18:08.170 thousand dollars. Yeah. And you get the benefits, 00:18:08.369 --> 00:18:10.609 your share of the rental income, your share of 00:18:10.609 --> 00:18:12.730 the appreciation, without having to manage the 00:18:12.730 --> 00:18:15.329 property yourself. It allows you to be a truly 00:18:15.329 --> 00:18:17.849 passive real estate investor. Okay, this is a 00:18:17.849 --> 00:18:20.349 perfect pivot point. We've talked about financial 00:18:20.349 --> 00:18:23.829 definitions, economic ideas. Now it's time to 00:18:23.829 --> 00:18:26.069 get into the weeds. For our listeners in the 00:18:26.069 --> 00:18:27.789 U .S., this is the most important part of the 00:18:27.789 --> 00:18:30.700 conversation. how the Internal Revenue Service 00:18:30.700 --> 00:18:33.579 sees all of this. This is where things get complicated 00:18:33.579 --> 00:18:36.460 and where the definition of passive income becomes 00:18:36.460 --> 00:18:40.500 incredibly specific and, frankly, counterintuitive. 00:18:40.859 --> 00:18:43.660 The IRS, as we mentioned, has three main buckets 00:18:43.660 --> 00:18:47.200 for income, active, passive, and portfolio. And 00:18:47.200 --> 00:18:49.180 that distinction between passive and portfolio 00:18:49.180 --> 00:18:52.400 is the one that trips up 99 % of people. So laid 00:18:52.400 --> 00:18:55.809 out for us. What to the IRS is actually passive 00:18:55.809 --> 00:18:58.150 income? It is an extremely narrow definition. 00:18:58.329 --> 00:19:00.869 According to the IRS, passive income comes from 00:19:00.869 --> 00:19:03.910 only two and only two types of passive activities. 00:19:04.029 --> 00:19:07.150 The first is rental activity. The second is trade 00:19:07.150 --> 00:19:09.690 or business activities in which you do not materially 00:19:09.690 --> 00:19:12.190 participate. That's it. That's it. Which means. 00:19:12.720 --> 00:19:14.319 All that interest you earn from your savings 00:19:14.319 --> 00:19:15.980 account, all those dividends you get from your 00:19:15.980 --> 00:19:18.299 index fund, that is not passive income to the 00:19:18.299 --> 00:19:21.279 IRS. That is portfolio income. That is, I think, 00:19:21.319 --> 00:19:23.880 the single most important clarification we can 00:19:23.880 --> 00:19:25.980 make. A million dollars in dividends is portfolio. 00:19:26.380 --> 00:19:28.839 A million dollars from a passively managed apartment 00:19:28.839 --> 00:19:32.160 complex is passive activity income. Why does 00:19:32.160 --> 00:19:34.000 the IRS care so much about this distinction? 00:19:34.400 --> 00:19:36.680 It all comes down to losses, specifically the 00:19:36.680 --> 00:19:39.319 passive activity loss rules. OK. The general 00:19:39.319 --> 00:19:42.279 rule is that you can only use losses. from a 00:19:42.279 --> 00:19:45.480 passive activity to offset income from other 00:19:45.480 --> 00:19:48.059 passive activities. You can't, for example, use 00:19:48.059 --> 00:19:50.500 a big loss from your rental property to reduce 00:19:50.500 --> 00:19:53.039 the taxable income from your high paying doctor 00:19:53.039 --> 00:19:55.519 salary. Ah, I see. It's a firewall. It's a firewall. 00:19:56.170 --> 00:19:58.450 If the IRS didn't make this rigid distinction, 00:19:58.750 --> 00:20:01.509 you can imagine what would happen. Wealthy individuals 00:20:01.509 --> 00:20:04.789 could buy up real estate, generate huge paper 00:20:04.789 --> 00:20:07.630 losses through things like depreciation, and 00:20:07.630 --> 00:20:10.289 then use those passive losses to wipe out all 00:20:10.289 --> 00:20:12.309 the taxes on their high -tax portfolio income 00:20:12.309 --> 00:20:15.329 from stocks and bonds. This rule prevents that. 00:20:15.710 --> 00:20:17.430 OK, that makes sense. So let's dig into those 00:20:17.430 --> 00:20:20.390 two categories. First, the trade or business 00:20:20.390 --> 00:20:22.730 where you don't materially participate. We keep 00:20:22.730 --> 00:20:24.829 using that phrase. How does the IRS actually 00:20:24.829 --> 00:20:27.710 measure material participation? They measure 00:20:27.710 --> 00:20:29.349 it with what are known as the seven material 00:20:29.349 --> 00:20:32.170 participation tests. The burden is on you, the 00:20:32.170 --> 00:20:34.890 taxpayer, to prove you meet one of these tests 00:20:34.890 --> 00:20:37.009 if you want your income to be considered active. 00:20:37.150 --> 00:20:39.029 Let's go through the big ones. The biggest, the 00:20:39.029 --> 00:20:42.670 clearest is quantitative. It's the 500 hour rule. 00:20:43.460 --> 00:20:45.759 If you participate in the activity for more than 00:20:45.759 --> 00:20:48.579 500 hours during the tax year period, you are 00:20:48.579 --> 00:20:50.720 materially participating. The income is active. 00:20:50.880 --> 00:20:52.819 So if I own a little bookstore and I'm there 00:20:52.819 --> 00:20:55.000 working 10 hours a week every week, I've cleared 00:20:55.000 --> 00:20:57.740 the 500 -hour rule. It's active income. Absolutely. 00:20:57.900 --> 00:20:59.920 No question. But what if it's a very small business? 00:21:00.019 --> 00:21:02.640 Maybe it only requires a couple hours a week 00:21:02.640 --> 00:21:05.819 total. That brings us to the second test, substantially 00:21:05.819 --> 00:21:09.180 all participation. If your participation makes 00:21:09.180 --> 00:21:11.900 up... well, substantially, all of the participation 00:21:11.900 --> 00:21:14.640 from everyone involved, including people who 00:21:14.640 --> 00:21:18.059 aren't owners, then you materially participate. 00:21:18.460 --> 00:21:20.619 So if I have a little side business selling things 00:21:20.619 --> 00:21:23.240 online and I only spend 80 hours on it all year, 00:21:23.299 --> 00:21:25.279 but my spouse or an employee doesn't do anything, 00:21:25.460 --> 00:21:27.220 I'm still the one doing all the work. You're 00:21:27.220 --> 00:21:29.859 doing all the work, so it's active. This prevents 00:21:29.859 --> 00:21:31.779 someone from claiming their income is passive 00:21:31.779 --> 00:21:34.250 just because the business is small. There are 00:21:34.250 --> 00:21:37.309 other tests, too, like the significant participation 00:21:37.309 --> 00:21:40.509 activity rule, which is a bit complex, but it 00:21:40.509 --> 00:21:42.910 basically looks at your total time across several 00:21:42.910 --> 00:21:45.109 different activities. And there are look back 00:21:45.109 --> 00:21:47.890 rules like the five out of 10 rule, which says 00:21:47.890 --> 00:21:50.450 if you materially participated in five of the 00:21:50.450 --> 00:21:52.829 last 10 years, you're still considered active. 00:21:52.910 --> 00:21:55.450 It's pretty clear they've built a very high, 00:21:55.650 --> 00:21:59.579 very dense fence. To stop people from just, you 00:21:59.579 --> 00:22:01.539 know, showing up for an hour awake and calling 00:22:01.539 --> 00:22:04.200 their business income passive. An extremely dense 00:22:04.200 --> 00:22:06.259 fence, yes. Okay, let's move to the other big 00:22:06.259 --> 00:22:08.859 category of passive activity, rental activities. 00:22:09.319 --> 00:22:11.839 This seems more straightforward, but the sources 00:22:11.839 --> 00:22:14.000 say there are some major exceptions. Right, the 00:22:14.000 --> 00:22:16.180 basic definition is an activity where people 00:22:16.180 --> 00:22:19.839 pay you to use your tangible property. There 00:22:19.839 --> 00:22:22.299 are four key situations where your rental is 00:22:22.299 --> 00:22:25.180 not considered a passive activity, even if you're 00:22:25.180 --> 00:22:27.359 not personally involved. And the first one feels 00:22:27.359 --> 00:22:29.079 like it was written specifically for the age 00:22:29.079 --> 00:22:31.859 of Airbnb, the seven -day rule. The seven -day 00:22:31.859 --> 00:22:35.109 rule. If the average period a customer uses your 00:22:35.109 --> 00:22:38.569 property is seven days or less, it is not a rental 00:22:38.569 --> 00:22:41.190 activity in the eyes of the IRS. So short -term 00:22:41.190 --> 00:22:43.769 rentals? Vacation rentals? They're not passive 00:22:43.769 --> 00:22:46.369 rental activities. The IRS views that as running 00:22:46.369 --> 00:22:48.890 a hospitality business, which is an active trader 00:22:48.890 --> 00:22:51.470 business. It's more like a hotel than a long 00:22:51.470 --> 00:22:54.490 -term lease. The constant turnover of guests 00:22:54.490 --> 00:22:56.930 requires a level of management that pushes it 00:22:56.930 --> 00:22:59.369 into the active category, regardless of whether 00:22:59.369 --> 00:23:01.630 you hire a company to do the cleaning. That's 00:23:01.630 --> 00:23:04.130 a huge distinction. So if my average guest stays 00:23:04.130 --> 00:23:07.049 for six days, I'm running a business. If my average 00:23:07.049 --> 00:23:09.109 guest stays for eight days, I might have a passive 00:23:09.109 --> 00:23:11.609 rental. Wow. Okay, what if the stay is a little 00:23:11.609 --> 00:23:14.029 longer? That takes us to exception number two, 00:23:14.130 --> 00:23:16.970 the 30 -day rule. If the average stay is 30 days 00:23:16.970 --> 00:23:19.369 or less, and you provide significant personal 00:23:19.369 --> 00:23:21.910 services to the guests. What counts as significant 00:23:21.910 --> 00:23:24.049 personal services? This is where it gets really 00:23:24.049 --> 00:23:26.650 granular. Let's say you're renting out furnished 00:23:26.650 --> 00:23:29.700 corporate apartments for three -week stays. If 00:23:29.700 --> 00:23:32.299 you also provide daily cleaning, a concierge 00:23:32.299 --> 00:23:35.359 service, maybe you stock the fridge. Those are 00:23:35.359 --> 00:23:37.819 significant personal services. That makes it 00:23:37.819 --> 00:23:40.619 an active business. But what if I just, you know, 00:23:40.619 --> 00:23:42.660 have the common areas of my apartment building 00:23:42.660 --> 00:23:45.039 cleaned once a week? Or I send a plumber when 00:23:45.039 --> 00:23:47.559 a pipe bursts? The IRS is very clear on this. 00:23:47.680 --> 00:23:50.220 That does not count. Routine maintenance, repairs, 00:23:50.660 --> 00:23:54.059 cleaning common areas. Those are considered standard 00:23:54.059 --> 00:23:56.759 custodial duties of a landlord, not significant 00:23:56.759 --> 00:23:59.359 personal services. The service has to be specific 00:23:59.359 --> 00:24:01.859 and substantial to that customer's stay. So the 00:24:01.859 --> 00:24:03.980 difference between a passive rental and an active 00:24:03.980 --> 00:24:06.299 business can literally come down to how often 00:24:06.299 --> 00:24:09.660 you change the towels. It absolutely can. The 00:24:09.660 --> 00:24:12.400 other two exceptions are a bit more niche. One 00:24:12.400 --> 00:24:15.240 is for extraordinary personal services. Think 00:24:15.240 --> 00:24:17.779 of a hospital or a boarding school. You're paying 00:24:17.779 --> 00:24:20.119 for the medical care or the education. The room 00:24:20.119 --> 00:24:23.289 is just... incidental. The other is if the rental 00:24:23.289 --> 00:24:25.910 is just a tiny part of a larger investment strategy, 00:24:26.170 --> 00:24:29.069 like you're holding land mainly for appreciation 00:24:29.069 --> 00:24:31.349 and you rent a tiny piece of it for a cell tower. 00:24:31.569 --> 00:24:34.809 Okay, let's look at the second main type of passive 00:24:34.809 --> 00:24:37.190 activity again, trade or business. We talked 00:24:37.190 --> 00:24:39.210 about the silent partner. Right. A trade or business 00:24:39.210 --> 00:24:41.509 activity is just running any kind of business. 00:24:41.809 --> 00:24:44.069 The way it becomes passive is through your non 00:24:44.069 --> 00:24:46.849 -participation. The classic example is a limited 00:24:46.849 --> 00:24:49.349 partner. You provide the capital for a new restaurant, 00:24:49.509 --> 00:24:51.450 you get a share of the profits, but you have 00:24:51.450 --> 00:24:54.109 zero role in the daily operations. You don't 00:24:54.109 --> 00:24:55.970 hire staff, you don't choose the menu. You don't 00:24:55.970 --> 00:24:57.589 meet any of those seven material participation 00:24:57.589 --> 00:25:00.890 tests. You don't come close. So your share of 00:25:00.890 --> 00:25:03.190 the profits is classic passive income under the 00:25:03.190 --> 00:25:06.089 IRS definition. Okay, two final very technical 00:25:06.089 --> 00:25:08.390 U .S. classifications from our sources. First, 00:25:08.609 --> 00:25:11.029 royalties. When are they passive? This is another 00:25:11.029 --> 00:25:13.970 tricky one. The IRS says royalties are passive. 00:25:14.440 --> 00:25:16.599 only when they are not derived in the ordinary 00:25:16.599 --> 00:25:18.299 course of a trade or business. What does that 00:25:18.299 --> 00:25:21.400 mean? It means if you are a professional musician 00:25:21.400 --> 00:25:24.640 who writes and actively promotes your music, 00:25:24.859 --> 00:25:27.420 the royalties you get are active business income. 00:25:28.460 --> 00:25:31.839 But if you, say, inherit the patent for your 00:25:31.839 --> 00:25:34.000 great uncle's invention from the 1970s and you 00:25:34.000 --> 00:25:35.559 just get a check from a company that licenses 00:25:35.559 --> 00:25:38.140 it, that's passive. You're not in the business 00:25:38.140 --> 00:25:40.539 of inventing. You're just a passive owner of 00:25:40.539 --> 00:25:43.000 the asset. And finally, something called self 00:25:43.000 --> 00:25:46.000 -charged interest. This sounds incredibly technical. 00:25:46.279 --> 00:25:48.759 It is, and it's designed to fix a very specific 00:25:48.759 --> 00:25:51.660 potential tax problem. Self -charged interest 00:25:51.660 --> 00:25:53.819 can be treated as passive income if the loan 00:25:53.819 --> 00:25:55.799 proceeds are used in a passive activity. Give 00:25:55.799 --> 00:25:58.480 me an example. Okay. Say you personally own LLC, 00:25:58.740 --> 00:26:01.779 and that LLC owns a rental property, which is 00:26:01.779 --> 00:26:04.759 a passive activity. The LLC needs cash for a 00:26:04.759 --> 00:26:08.059 new roof, so you personally lend $20 ,000 to 00:26:08.059 --> 00:26:10.940 your own LLC. So I'm both the lender and, through 00:26:10.940 --> 00:26:14.299 my company, the borrower. Exactly. Now, the LLC 00:26:14.299 --> 00:26:16.740 pays you interest. Normally, that interest you 00:26:16.740 --> 00:26:19.259 receive would be portfolio income. Meanwhile, 00:26:19.400 --> 00:26:21.819 the interest the LLC pays is a passive activity 00:26:21.819 --> 00:26:24.380 expense. You see the mismatch. Yeah, I'd have 00:26:24.380 --> 00:26:27.200 portfolio income, which is taxed, and a passive 00:26:27.200 --> 00:26:29.460 loss, which I might not be able to use. Precisely. 00:26:29.480 --> 00:26:31.859 The self -charged interest rule allows you to 00:26:31.859 --> 00:26:33.819 recharacterize some of that portfolio interest 00:26:33.819 --> 00:26:36.880 income as passive income, so you can offset it 00:26:36.880 --> 00:26:39.279 with the passive interest expense. It's a fairness 00:26:39.279 --> 00:26:41.359 mechanism for when you transact with your own 00:26:41.359 --> 00:26:44.380 passive entity. The level of detail here just 00:26:44.380 --> 00:26:46.740 proves that this whole U .S. system is built 00:26:46.740 --> 00:26:49.460 to prevent people from gaming the rules. And 00:26:49.460 --> 00:26:51.519 yet the reality, according to our notes, is that 00:26:51.519 --> 00:26:54.180 only about 20 percent of Americans get any passive 00:26:54.180 --> 00:26:57.500 income at all. And for most of them, it's a tiny 00:26:57.500 --> 00:27:00.680 amount, less than $5 ,000 a year, mostly from 00:27:00.680 --> 00:27:02.839 a little bit of interest, some small dividends 00:27:02.839 --> 00:27:06.440 or maybe getting rent from a roommate. The overwhelming 00:27:06.440 --> 00:27:08.779 majority of people are earning active income, 00:27:08.880 --> 00:27:11.059 which takes us right back to that wage tax critique. 00:27:11.549 --> 00:27:14.410 It really does. OK, that deep dive into the US 00:27:14.410 --> 00:27:18.130 system is fascinating and it shows just how much 00:27:18.130 --> 00:27:21.130 the tax code shapes the definition. So let's 00:27:21.130 --> 00:27:23.630 zoom out. How do other major countries handle 00:27:23.630 --> 00:27:26.630 this? It's a great question because the US complexity 00:27:26.630 --> 00:27:29.309 really highlights what happens when a tax authority 00:27:29.309 --> 00:27:31.970 gets granular. Other places are different and 00:27:31.970 --> 00:27:34.789 some don't even really try to define it at all. 00:27:34.930 --> 00:27:37.789 Let's start with Europe. Is there a single EU 00:27:37.789 --> 00:27:40.690 -wide definition? Not at all. There's no single 00:27:40.690 --> 00:27:42.950 word or formal definition for passive income 00:27:42.950 --> 00:27:45.410 from the European Commission. Taxation is still 00:27:45.410 --> 00:27:47.289 a power held by the individual member states. 00:27:47.349 --> 00:27:50.349 So the rules for taxing, say, rental income in 00:27:50.349 --> 00:27:52.509 Spain, are completely different from the rules 00:27:52.509 --> 00:27:54.630 in Sweden. It creates a lot of complexity for 00:27:54.630 --> 00:27:56.789 anyone investing across the continent. But there 00:27:56.789 --> 00:27:58.569 is some international guidance, right, from the 00:27:58.569 --> 00:28:02.289 OECD. Yes, and this is very important. The OECD's 00:28:02.289 --> 00:28:05.490 Common Reporting Standard, or CRS, is a global 00:28:05.490 --> 00:28:07.589 framework designed to get countries to automatically 00:28:07.589 --> 00:28:09.630 share financial information with each other. 00:28:09.710 --> 00:28:12.890 To stop tax evasion. Primarily, yes. Now, the 00:28:12.890 --> 00:28:15.210 CRS doesn't formally define passive income either. 00:28:15.900 --> 00:28:18.140 But it gives a guiding list to all the signatory 00:28:18.140 --> 00:28:19.900 countries of what kind of income they should 00:28:19.900 --> 00:28:22.000 be looking for. And that list includes things 00:28:22.000 --> 00:28:24.740 like dividends, interest, non -active rents and 00:28:24.740 --> 00:28:27.319 royalties, annuities, and gains from selling 00:28:27.319 --> 00:28:30.160 financial assets. So it's a much broader source 00:28:30.160 --> 00:28:33.160 -based list than the IRS's narrow activity -based 00:28:33.160 --> 00:28:36.119 one. Exactly. The IRS is basically saying if 00:28:36.119 --> 00:28:38.400 the income is coming from capital, not labor. 00:28:38.859 --> 00:28:41.700 We need to be tracking it. It's all about preventing 00:28:41.700 --> 00:28:43.900 people from hiding their investment profits in 00:28:43.900 --> 00:28:46.400 a low tax country without reporting it back home. 00:28:46.519 --> 00:28:48.619 OK, now let's go to China, because this is where 00:28:48.619 --> 00:28:50.900 that tension we talked about taxing capital versus 00:28:50.900 --> 00:28:53.400 taxing labor gets really dramatic. China is one 00:28:53.400 --> 00:28:55.099 of the most interesting examples in our material. 00:28:55.500 --> 00:28:58.400 China has a proportional or flat tax rate of 00:28:58.400 --> 00:29:01.720 20 percent for passive and unearned income, especially 00:29:01.720 --> 00:29:04.519 capital gains. A flat 20 percent tax on investment 00:29:04.519 --> 00:29:07.539 profits. A flat 20 percent. Now, compare that 00:29:07.539 --> 00:29:10.019 to their tax on active income on wages and salaries. 00:29:10.119 --> 00:29:12.019 That's on a steeply progressive scale. It goes 00:29:12.019 --> 00:29:15.000 all the way up to 45 % for the highest earners. 00:29:15.160 --> 00:29:18.119 Wow. So the incentive is incredibly clear. It's 00:29:18.119 --> 00:29:21.500 massive. And the sources we have highlight the 00:29:21.500 --> 00:29:24.319 intense debate around this. Proponents will say 00:29:24.319 --> 00:29:26.859 that a low, flat tax on capital is good for the 00:29:26.859 --> 00:29:29.400 economy. It encourages investment, it attracts 00:29:29.400 --> 00:29:32.079 foreign capital, and it keeps wealthy people 00:29:32.079 --> 00:29:34.579 from just hiding their money. It's an efficiency 00:29:34.579 --> 00:29:37.140 argument. But the argument against it from an 00:29:37.140 --> 00:29:39.599 equity standpoint must be huge. It's the core 00:29:39.599 --> 00:29:42.420 of the critique. Yeah. Critics argue this system 00:29:42.420 --> 00:29:44.880 is fundamentally, or as they say, horizontally 00:29:44.880 --> 00:29:48.380 unfair. If a top surgeon earns a million dollars 00:29:48.380 --> 00:29:50.859 through her labor, she could pay a marginal rate 00:29:50.859 --> 00:29:53.630 near 45 percent. If an investor makes a million 00:29:53.630 --> 00:29:56.309 dollars by selling stock, he pays only 20 percent. 00:29:56.470 --> 00:29:59.569 That's a massive difference. It is. And the analysis 00:29:59.569 --> 00:30:01.849 in our sources suggests this structure fails 00:30:01.849 --> 00:30:04.130 to regulate the income distribution gap in China. 00:30:04.349 --> 00:30:07.569 In fact, it actively makes it worse by dramatically 00:30:07.569 --> 00:30:10.250 favoring wealth derived from ownership over wealth 00:30:10.250 --> 00:30:12.450 derived from effort. It's a real world example 00:30:12.450 --> 00:30:15.509 of that wage tax idea in action. Let's look at 00:30:15.509 --> 00:30:17.650 a couple of other specific examples. Russia and 00:30:17.650 --> 00:30:19.849 Kazakhstan have interesting approaches to securities. 00:30:20.130 --> 00:30:22.609 They do. Russia's system is all about the principle 00:30:22.609 --> 00:30:25.750 of realization. They have a 13 % tax on investment 00:30:25.750 --> 00:30:28.630 income, but it only applies when the income is 00:30:28.630 --> 00:30:30.829 actually realized. Meaning when it turns into 00:30:30.829 --> 00:30:33.230 cash. Exactly. When you sell the stock for a 00:30:33.230 --> 00:30:36.009 profit or when you receive a cash dividend or 00:30:36.009 --> 00:30:39.569 a bond coupon. So if you buy a Russian stock 00:30:39.569 --> 00:30:42.789 and its value on paper doubles, but you don't 00:30:42.789 --> 00:30:45.880 sell it. You pay zero tax. No tax on unrealized 00:30:45.880 --> 00:30:49.119 gains. None. The tax event only happens when 00:30:49.119 --> 00:30:51.599 you liquidate. And it's worth noting that for 00:30:51.599 --> 00:30:53.960 non -residents, the tax on dividends from Russian 00:30:53.960 --> 00:30:56.599 companies is a bit higher, at 15%. But what about 00:30:56.599 --> 00:30:58.700 Kazakhstan? They seem to use their tax policy 00:30:58.700 --> 00:31:01.039 to encourage local investment. They do. It's 00:31:01.039 --> 00:31:03.240 a very targeted incentive. They have a low 5 00:31:03.240 --> 00:31:05.940 % income tax on dividends. But here's the key. 00:31:06.039 --> 00:31:09.079 That dividend income... And any income from the 00:31:09.079 --> 00:31:12.000 stock's value increasing is completely tax exempt 00:31:12.000 --> 00:31:14.420 if the stock is on the official list of the local 00:31:14.420 --> 00:31:16.980 Kazakhstani stock exchanges. So it's a huge tax 00:31:16.980 --> 00:31:19.319 break, but only if you invest in Kazakhstani 00:31:19.319 --> 00:31:22.079 companies trading on local markets. Right. It's 00:31:22.079 --> 00:31:24.319 a clear policy choice designed to keep capital 00:31:24.319 --> 00:31:26.359 within the country and to bolster their domestic 00:31:26.359 --> 00:31:28.529 stock market. So if we bring it back to the U 00:31:28.529 --> 00:31:30.329 .S. one last time, just to frame all this, we 00:31:30.329 --> 00:31:33.630 have the three narrow IRS buckets, active, passive, 00:31:33.730 --> 00:31:36.150 portfolio, which are all about setting tax rules. 00:31:36.609 --> 00:31:39.190 But the sources mention the tax code also uses 00:31:39.190 --> 00:31:41.670 four broader categories to just define gross 00:31:41.670 --> 00:31:44.029 income. That's right. And it's a useful final 00:31:44.029 --> 00:31:46.549 clarification. Those four broad source categories 00:31:46.549 --> 00:31:50.529 are just a list. They are, one, income from labor, 00:31:50.630 --> 00:31:54.079 like wages. Two, income from capital, like dividends 00:31:54.079 --> 00:31:57.059 and interest. Three, income from transfer, like 00:31:57.059 --> 00:31:59.019 winning a prize or getting unemployment benefits. 00:31:59.359 --> 00:32:02.619 And four, a weird one called presumptive income, 00:32:02.759 --> 00:32:04.980 which covers things like below -market loans. 00:32:05.630 --> 00:32:07.450 And these are just to make sure all money is 00:32:07.450 --> 00:32:09.170 accounted for. They don't set the tax rates. 00:32:09.329 --> 00:32:11.450 Correct. They're just a checklist to define what 00:32:11.450 --> 00:32:13.430 counts as income in the first place. All the 00:32:13.430 --> 00:32:15.490 real policy work, the different tax rates, the 00:32:15.490 --> 00:32:17.710 loss rules, the credits. That all happens when 00:32:17.710 --> 00:32:20.549 the IRS applies those much narrower, much more 00:32:20.549 --> 00:32:24.089 complex definitions of active, passive and portfolio. 00:32:24.410 --> 00:32:26.450 It really confirms that this whole debate is 00:32:26.450 --> 00:32:28.950 less about the general idea of work and more 00:32:28.950 --> 00:32:31.609 about very specific legal rules written to define 00:32:31.609 --> 00:32:34.049 the value of capital versus the value of labor. 00:32:34.400 --> 00:32:37.400 a perfect place to wrap up our deep dive so we've 00:32:37.400 --> 00:32:39.440 gone on quite a journey today we started with 00:32:39.440 --> 00:32:42.210 this you know, glossy promise of easy wealth. 00:32:42.410 --> 00:32:44.730 And we've ended up deep in the technical guts 00:32:44.730 --> 00:32:47.089 of global tax codes. We certainly have. And I 00:32:47.089 --> 00:32:48.809 think the most crucial takeaway for you, the 00:32:48.809 --> 00:32:51.490 listener, is that passive income isn't just a 00:32:51.490 --> 00:32:54.309 simple catchphrase. It's a highly technical, 00:32:54.589 --> 00:32:57.910 legally defined concept. And that definition 00:32:57.910 --> 00:33:00.809 can change dramatically depending on whether 00:33:00.809 --> 00:33:02.329 you're talking to your financial planner about 00:33:02.329 --> 00:33:05.029 your retirement goals or to your accountant about 00:33:05.029 --> 00:33:08.089 your tax liability. That's the key. What an investor 00:33:08.089 --> 00:33:10.509 calls passive and what the IRS calls passive 00:33:10.509 --> 00:33:12.970 can be two totally different things. Absolutely. 00:33:13.269 --> 00:33:15.650 The stock dividends that everyone thinks of as 00:33:15.650 --> 00:33:18.390 passive, the IRS calls that portfolio income. 00:33:18.650 --> 00:33:21.630 And it's not just semantics. It has huge implications 00:33:21.630 --> 00:33:24.069 for how your losses are treated and how your 00:33:24.069 --> 00:33:26.730 income is taxed. For me, the thing that really 00:33:26.730 --> 00:33:28.990 stands out, the surprising fact that proves how 00:33:28.990 --> 00:33:32.069 technical this gets, is that IRS scrutiny of 00:33:32.069 --> 00:33:35.059 rental activities. That seven -day rule. The 00:33:35.059 --> 00:33:36.940 idea that if you rent your place out for an average 00:33:36.940 --> 00:33:39.700 of six days, it's an active business. But if 00:33:39.700 --> 00:33:41.480 you rent it out for an average of eight days, 00:33:41.640 --> 00:33:44.400 it might be a passive activity. Or the specific 00:33:44.400 --> 00:33:46.819 definitions of what does and doesn't count as 00:33:46.819 --> 00:33:49.799 a significant personal service. It just shows 00:33:49.799 --> 00:33:52.240 that the difference between two completely different 00:33:52.240 --> 00:33:55.119 tax treatments can come down to whether you offer 00:33:55.119 --> 00:33:57.660 a daily turndown service. It's that granular. 00:33:58.299 --> 00:34:00.380 And that kind of detail shows you the complex 00:34:00.380 --> 00:34:02.599 guardrails that are required to draw a line between 00:34:02.599 --> 00:34:05.380 capital and labor in our economy. And that leads 00:34:05.380 --> 00:34:07.539 us to our final provocative thought for you to 00:34:07.539 --> 00:34:09.179 consider. Based on everything we've discussed, 00:34:09.360 --> 00:34:12.340 we've seen a clear global trend, right, in the 00:34:12.340 --> 00:34:15.179 U .S. with how portfolio income is taxed and 00:34:15.179 --> 00:34:18.159 very sharply in China with their flat capital 00:34:18.159 --> 00:34:21.239 gains tax versus their progressive wage tax. 00:34:21.460 --> 00:34:23.519 The trend is that income from owning capital 00:34:23.519 --> 00:34:26.000 is generally taxed at a lower, often proportional 00:34:26.000 --> 00:34:28.750 rate. while income from active labor is taxed 00:34:28.750 --> 00:34:30.889 at higher progressive rates. The wage tax. The 00:34:30.889 --> 00:34:33.130 wage tax. So the question to leave you with is 00:34:33.130 --> 00:34:35.969 this. What is the long -term impact of that policy 00:34:35.969 --> 00:34:39.630 choice on our very definition of effort in achieving 00:34:39.630 --> 00:34:43.349 wealth? And more fundamentally, how might our 00:34:43.349 --> 00:34:45.730 tax codes, both here and around the world, need 00:34:45.730 --> 00:34:47.469 to evolve if they want to address this growing 00:34:47.469 --> 00:34:49.449 horizontal inequity between those who earn money 00:34:49.449 --> 00:34:51.090 with their time and those who earn it with their 00:34:51.090 --> 00:34:51.409 capital?