WEBVTT 00:00:00.000 --> 00:00:02.680 Welcome back to the Deep Dive. I want you to 00:00:02.680 --> 00:00:06.120 picture something with me for a second. It's 00:00:06.120 --> 00:00:09.119 an image I see probably 10 times a day. Oh, I 00:00:09.119 --> 00:00:11.359 think I know where this is going. Yeah. I'm scrolling 00:00:11.359 --> 00:00:14.400 through Instagram or maybe LinkedIn, and I see 00:00:14.400 --> 00:00:17.239 a guy, and let's be honest, it is almost always 00:00:17.239 --> 00:00:19.780 a guy. Right. He's sitting on some teak deck 00:00:19.780 --> 00:00:22.820 in Bali. He's got a laptop open, but he's not 00:00:22.820 --> 00:00:24.579 even looking at it. He's looking out at the ocean. 00:00:24.739 --> 00:00:27.500 Of course. And the caption, it always says something 00:00:27.500 --> 00:00:30.960 like, I made $5 ,000 while I slept last night. 00:00:31.359 --> 00:00:34.429 Ask me how. It's the modern siren song, isn't 00:00:34.429 --> 00:00:36.929 it? It is, I think, the most pervasive marketing 00:00:36.929 --> 00:00:39.909 pitch of the last decade. It really is. The dream 00:00:39.909 --> 00:00:42.810 of passive income. It feels like the holy grail 00:00:42.810 --> 00:00:44.630 of modern economics, at least for the average 00:00:44.630 --> 00:00:46.670 person. Right. We're not just being sold a financial 00:00:46.670 --> 00:00:49.590 product. We're being sold an exit strategy. An 00:00:49.590 --> 00:00:52.829 escape hatch. Exactly. The pitch is you can quit 00:00:52.829 --> 00:00:54.770 the nine to five. You can stop trading your time 00:00:54.770 --> 00:00:57.170 for money. And you just you build a machine that 00:00:57.170 --> 00:00:59.969 prints cash forever. It's a beautiful dream. 00:01:00.210 --> 00:01:03.450 I mean, frankly, who wouldn't want that? The 00:01:03.450 --> 00:01:05.750 idea of decoupling your survival from your labor 00:01:05.750 --> 00:01:10.090 is what it's the ultimate freedom is. But as 00:01:10.090 --> 00:01:12.129 we so often find on these deep dives, when you 00:01:12.129 --> 00:01:13.709 actually pull back the curtain and you look at 00:01:13.709 --> 00:01:16.469 the, you know, the accounting manuals, the tax 00:01:16.469 --> 00:01:19.969 codes, the actual economic theory, the reality 00:01:19.969 --> 00:01:23.670 is. Well, it's a lot stickier than the Instagram 00:01:23.670 --> 00:01:26.189 caption suggests. And that is exactly why we're 00:01:26.189 --> 00:01:28.469 here today. Yeah. We're going to strip away all 00:01:28.469 --> 00:01:31.209 of that influencer hype. We've got a stack of 00:01:31.209 --> 00:01:33.349 sources here that includes everything from IRS 00:01:33.349 --> 00:01:36.890 publications to these historical economic critiques 00:01:36.890 --> 00:01:39.650 from the 1930s and even some global tax comparisons. 00:01:39.769 --> 00:01:42.810 A pretty wide net. Our mission today is to figure 00:01:42.810 --> 00:01:45.750 out what passive income actually is, not what 00:01:45.750 --> 00:01:48.090 we wish it was, but what the law and the math 00:01:48.090 --> 00:01:51.010 says it is. And that distinction is just so critical 00:01:51.010 --> 00:01:53.109 because if you confuse the colloquial definition 00:01:53.109 --> 00:01:55.870 of easy money with the legal definition of passive 00:01:55.870 --> 00:01:58.230 income, you're not just setting yourself up for 00:01:58.230 --> 00:02:00.730 disappointment. You are potentially setting yourself 00:02:00.730 --> 00:02:03.269 up for a massive tax audit. And nobody wants 00:02:03.269 --> 00:02:05.950 that. No, definitely not. So let's start at the 00:02:05.950 --> 00:02:09.030 very bottom, the bedrock. Yeah. If we're looking 00:02:09.030 --> 00:02:11.330 at the source material. How do we fundamentally 00:02:11.330 --> 00:02:14.270 define passive income? Okay, so if we're being 00:02:14.270 --> 00:02:17.050 really strict, looking at the economic and accounting 00:02:17.050 --> 00:02:21.310 definitions, passive income is defined as unearned 00:02:21.310 --> 00:02:24.129 income that is acquired with little to no labor 00:02:24.129 --> 00:02:27.689 to earn or maintain it. Little to no labor. That 00:02:27.689 --> 00:02:30.389 seems to be the operative phrase, doesn't it? 00:02:30.620 --> 00:02:33.280 It is. And to really get it, you have to contrast 00:02:33.280 --> 00:02:35.699 it with what, you know, the vast majority of 00:02:35.699 --> 00:02:38.199 our listeners are doing right now to earn a living. 00:02:38.360 --> 00:02:40.340 Which is earning active income. Earning active 00:02:40.340 --> 00:02:42.780 income. The standard trade. I give you an hour 00:02:42.780 --> 00:02:44.539 of my life. You give me a set amount of dollars. 00:02:44.740 --> 00:02:48.060 Exactly. Wages, salaries, tips, commissions. 00:02:48.219 --> 00:02:50.319 It doesn't matter if you're a high powered lawyer 00:02:50.319 --> 00:02:52.960 billing a thousand dollars an hour. That is still 00:02:52.960 --> 00:02:55.219 active income. Because if you stop showing up. 00:02:55.300 --> 00:02:57.159 The money stops flowing. You are the engine. 00:02:57.800 --> 00:03:00.379 With passive income, the whole goal is to build 00:03:00.379 --> 00:03:02.520 a machine, step away from it, and have it keep 00:03:02.520 --> 00:03:04.719 running on its own. Okay, so that seems simple 00:03:04.719 --> 00:03:07.379 enough. Bucket A is work. Bucket B is not work. 00:03:07.879 --> 00:03:12.159 But looking at our notes here, the IRS, they 00:03:12.159 --> 00:03:14.539 throw a wrench in the gears right away. They 00:03:14.539 --> 00:03:17.400 love to do that. They do. Because I think most 00:03:17.400 --> 00:03:19.280 people, myself included, would probably say, 00:03:19.319 --> 00:03:21.620 okay, I buy a stock, I get a dividend check, 00:03:21.780 --> 00:03:25.210 that's passive income. But the tax man disagrees. 00:03:25.389 --> 00:03:27.430 Yeah. This is probably the first and biggest 00:03:27.430 --> 00:03:29.189 misconception we need to clear up. For the IRS, 00:03:29.330 --> 00:03:31.069 it's not just two buckets. They have three. Three 00:03:31.069 --> 00:03:33.110 buckets. Three buckets. So bucket one is your 00:03:33.110 --> 00:03:34.889 active income. We just covered that. Bucket two 00:03:34.889 --> 00:03:37.550 is passive income. But bucket three is what they 00:03:37.550 --> 00:03:39.930 call portfolio income. Portfolio income. OK. 00:03:39.990 --> 00:03:42.210 Right. And this bucket covers things like dividends, 00:03:42.409 --> 00:03:46.050 interest and capital gains. So strictly speaking, 00:03:46.270 --> 00:03:48.430 when you buy a share of Apple and get that dividend 00:03:48.430 --> 00:03:50.750 or you put money in a savings account and get 00:03:50.750 --> 00:03:52.939 some interest. Which is almost nothing these 00:03:52.939 --> 00:03:55.819 days. Right. But even that tiny amount, the IRS 00:03:55.819 --> 00:03:58.439 classifies that as portfolio income, not passive 00:03:58.439 --> 00:04:00.759 income. Why does that distinction matter? I mean, 00:04:00.759 --> 00:04:03.939 is it just semantics? Or does it have real world 00:04:03.939 --> 00:04:06.840 consequences? Oh, it has huge consequences when 00:04:06.840 --> 00:04:09.360 you get to tax time. Specifically, it matters 00:04:09.360 --> 00:04:12.300 when it comes to losses. Let's say you have what 00:04:12.300 --> 00:04:15.460 the IRS defines as passive losses, maybe from 00:04:15.460 --> 00:04:17.459 a rental property that's not making money yet. 00:04:17.720 --> 00:04:20.279 You generally cannot use those passive losses 00:04:20.279 --> 00:04:23.439 to offset your portfolio income. So you can't 00:04:23.439 --> 00:04:25.779 use your bad real estate deal to cancel out the 00:04:25.779 --> 00:04:28.540 taxes on your stock games. You got it. They're 00:04:28.540 --> 00:04:31.540 siloed. The IRS wants to keep them separate to 00:04:31.540 --> 00:04:33.699 prevent people from, you know, sheltering their 00:04:33.699 --> 00:04:36.420 investment gains with paper losses from completely 00:04:36.420 --> 00:04:39.139 different ventures. It's a way to stop people 00:04:39.139 --> 00:04:41.560 from gaming the system. That's really interesting. 00:04:41.720 --> 00:04:43.720 So for the rest of this conversation, we're probably 00:04:43.720 --> 00:04:46.279 going to talk about passive income in that broader, 00:04:46.319 --> 00:04:48.600 more colloquial sense. Money you don't actively 00:04:48.600 --> 00:04:51.319 work for. Right. Money you don't work for. But 00:04:51.319 --> 00:04:53.779 we have to keep that legal asterisk in our minds 00:04:53.779 --> 00:04:56.740 that the IRS sees things differently. We do. 00:04:57.269 --> 00:05:00.569 And there's one more nuance from the expert side 00:05:00.569 --> 00:05:02.629 of our notes that I think really sets the stage 00:05:02.629 --> 00:05:04.009 for everything else we're going to talk about. 00:05:04.129 --> 00:05:07.050 Which is? The host perspective, the dream, the 00:05:07.050 --> 00:05:10.709 Bali deck, is that it's free money. Right. But 00:05:10.709 --> 00:05:13.490 the source material emphasizes over and over 00:05:13.490 --> 00:05:17.009 again, passive income is almost never free. It 00:05:17.009 --> 00:05:19.810 is an acquired income. What do you mean by acquired? 00:05:20.250 --> 00:05:22.290 It means it usually requires one of two things. 00:05:22.750 --> 00:05:26.490 Either a massive upfront accumulation of capital. 00:05:26.689 --> 00:05:31.509 Cash. Lots of cash. Or it requires a long, intense 00:05:31.509 --> 00:05:35.230 period of work, often unpaid work, before that 00:05:35.230 --> 00:05:37.750 passive phase can even begin. So you're either 00:05:37.750 --> 00:05:39.810 paying for it with cash you already earned through 00:05:39.810 --> 00:05:42.019 active work. Or you're paying for it with sweat 00:05:42.019 --> 00:05:43.920 equity up front. There's no escaping the payment. 00:05:44.199 --> 00:05:46.259 Precisely. You have to build the hydroelectric 00:05:46.259 --> 00:05:48.579 dam before you can sit back and watch the reservoir 00:05:48.579 --> 00:05:50.399 fill up. You can't just stand by the river and 00:05:50.399 --> 00:05:52.620 expect electricity. That is a perfect analogy. 00:05:52.939 --> 00:05:54.560 Okay. Okay, so let's map out where we're going 00:05:54.560 --> 00:05:56.420 today. We're going to start by looking at the 00:05:56.420 --> 00:06:00.120 different vehicles for this income from the boring 00:06:00.120 --> 00:06:03.329 bank accounts to... The volatile stock market. 00:06:03.410 --> 00:06:05.350 A whole spectrum of risk. Then we're going to 00:06:05.350 --> 00:06:06.850 get into real estate, which, as I mentioned, 00:06:06.910 --> 00:06:09.149 has some fascinating philosophical baggage attached 00:06:09.149 --> 00:06:12.110 to it. The improperty concept. Yes, I'm excited 00:06:12.110 --> 00:06:14.290 to get to that. It's a real mind bender. And 00:06:14.290 --> 00:06:16.870 then we'll touch on the new digital world, the 00:06:16.870 --> 00:06:19.529 so -called loopholes or strategies, depending 00:06:19.529 --> 00:06:21.730 on who you ask. Right. And finally, we'll take 00:06:21.730 --> 00:06:23.850 a trip around the world to see how countries 00:06:23.850 --> 00:06:27.350 like China and Russia and even Kazakhstan handle 00:06:27.350 --> 00:06:30.389 this kind of wealth. Sounds like a plan. OK, 00:06:30.509 --> 00:06:33.930 let's jump into section one, the spectrum of 00:06:33.930 --> 00:06:36.870 income sources. And let's start with, I think, 00:06:36.870 --> 00:06:39.110 the safest, maybe the dullest place you can put 00:06:39.110 --> 00:06:42.810 your money, the bank. Deposits. Yeah, it's not 00:06:42.810 --> 00:06:45.649 sexy, but it is the absolute foundation of the 00:06:45.649 --> 00:06:48.529 financial system. The idea here is about as simple 00:06:48.529 --> 00:06:51.129 as it gets. I give the bank my money. They hold 00:06:51.129 --> 00:06:53.389 it. They pay me interest. But let's be real. 00:06:53.490 --> 00:06:57.490 A standard savings account pays. What, pennies? 00:06:57.589 --> 00:07:00.149 In many economic climates, yes. I mean, the real 00:07:00.149 --> 00:07:02.329 rate of return can actually be negative once 00:07:02.329 --> 00:07:04.829 you factor in inflation. Your money is losing 00:07:04.829 --> 00:07:07.029 purchasing power. So what's the actual passive 00:07:07.029 --> 00:07:09.449 income vehicle here? The sources highlight a 00:07:09.449 --> 00:07:12.709 specific one, the certificate of deposit or a 00:07:12.709 --> 00:07:15.790 CD. Ah, the CD. I remember my grandmother giving 00:07:15.790 --> 00:07:17.769 me a CD for my birthday when I was a kid. I was 00:07:17.769 --> 00:07:19.290 so disappointed because I couldn't spend it. 00:07:19.410 --> 00:07:22.290 That is the entire mechanism of the CD. It's 00:07:22.290 --> 00:07:25.410 a contract. You are literally agreeing to lock 00:07:25.410 --> 00:07:28.069 away a fixed amount of money for a fixed period 00:07:28.069 --> 00:07:31.610 of time, six months, a year, five years. You 00:07:31.610 --> 00:07:34.009 are selling your liquidity to the bank. And in 00:07:34.009 --> 00:07:36.110 exchange for me not being able to touch my own 00:07:36.110 --> 00:07:38.709 money, they pay me a slightly higher interest 00:07:38.709 --> 00:07:41.009 rate. Correct. It's a premium for stability. 00:07:41.709 --> 00:07:43.850 The bank can lend that money out with more confidence 00:07:43.850 --> 00:07:45.670 because they know you can't just walk in and 00:07:45.670 --> 00:07:47.449 demand it all back tomorrow without paying a 00:07:47.449 --> 00:07:49.529 massive penalty. Right, there are penalties for 00:07:49.529 --> 00:07:51.949 early withdrawal. Big ones, yeah. And the sources 00:07:51.949 --> 00:07:54.509 mention the scaling here. It's not a one -size 00:07:54.509 --> 00:07:57.209 -fits -all rate. No, not at all. Generally, a 00:07:57.209 --> 00:07:59.610 larger principle, meaning you deposit more money 00:07:59.610 --> 00:08:02.069 and a longer term will yield a better interest 00:08:02.069 --> 00:08:06.069 rate. A $10 ,000 five -year CD will pay a lot 00:08:06.069 --> 00:08:09.129 more than a $1 ,000 six -month CD. So what's 00:08:09.129 --> 00:08:11.800 the verdict on this? Who is this for? It is the 00:08:11.800 --> 00:08:16.079 definition of low risk, low reward. It prioritizes 00:08:16.079 --> 00:08:19.019 safety above all else. You aren't going to get 00:08:19.019 --> 00:08:21.660 rich off CD interest unless you start with millions 00:08:21.660 --> 00:08:24.160 and millions of dollars. But you also aren't 00:08:24.160 --> 00:08:25.899 going to wake up and find your account balance 00:08:25.899 --> 00:08:28.699 has dropped by 20 % overnight. Which brings us 00:08:28.699 --> 00:08:32.259 very neatly to the vehicle where you can wake 00:08:32.259 --> 00:08:35.700 up to a 20 % drop, the stock market. The market 00:08:35.700 --> 00:08:38.179 route. This is where the majority of, let's say, 00:08:38.590 --> 00:08:40.950 middle class passive wealth generation happens. 00:08:41.129 --> 00:08:43.269 OK, but we need to break down the two ways you 00:08:43.269 --> 00:08:45.610 actually make money here, because I think people 00:08:45.610 --> 00:08:47.750 conflate them all the time. There's growth and 00:08:47.750 --> 00:08:50.509 there is income. Yes. This is a really important 00:08:50.509 --> 00:08:53.230 distinction. Mechanism number one is value growth. 00:08:53.450 --> 00:08:56.490 You buy a share of a company for $100. The company 00:08:56.490 --> 00:08:59.169 does well. It innovates. Its market cap increases. 00:08:59.490 --> 00:09:02.809 The share is now worth $120. But that $20 is 00:09:02.809 --> 00:09:05.490 theoretical. Right. It's just a number on a screen 00:09:05.490 --> 00:09:08.509 until I sell it. Exactly. That is a capital gain 00:09:08.509 --> 00:09:11.629 and it is only realized upon sale. It's not income 00:09:11.629 --> 00:09:14.370 until you cash it out. The second mechanism, 00:09:14.509 --> 00:09:16.570 the part that feels more like passive income, 00:09:16.789 --> 00:09:19.769 is dividend payments. This is the actual check 00:09:19.769 --> 00:09:22.169 in the mail or the deposit in my account. That's 00:09:22.169 --> 00:09:24.529 right. This is distributed profit. The company 00:09:24.529 --> 00:09:27.009 made money, they covered their costs, they reinvested 00:09:27.009 --> 00:09:29.009 whatever they needed for future growth, and they 00:09:29.009 --> 00:09:32.009 still had a pile of cash left over. So they cut 00:09:32.009 --> 00:09:34.679 a check to the owners, the shareholders. The 00:09:34.679 --> 00:09:37.139 source material specifically mentions index funds 00:09:37.139 --> 00:09:39.799 here as the sort of default strategy for most 00:09:39.799 --> 00:09:42.639 people. Why is that? Because picking individual 00:09:42.639 --> 00:09:45.940 stocks is incredibly difficult. And the data 00:09:45.940 --> 00:09:48.259 shows that even most professionals can't beat 00:09:48.259 --> 00:09:50.519 the market over the long term. The whole monkey 00:09:50.519 --> 00:09:52.919 throwing darts at a newspaper thing. Pretty much. 00:09:52.960 --> 00:09:55.519 So an index fund like one that tracks the S &P 00:09:55.519 --> 00:09:58.720 500 allows you to buy a tiny slice of the entire 00:09:58.720 --> 00:10:01.360 market. You own a little piece of 500 of the 00:10:01.360 --> 00:10:03.360 biggest companies. You aren't betting on one 00:10:03.360 --> 00:10:05.779 horse. You're betting on the whole racetrack. 00:10:05.840 --> 00:10:08.740 It just mirrors the market indices. But unlike 00:10:08.740 --> 00:10:10.929 that CD we were just talking about. There is 00:10:10.929 --> 00:10:13.470 absolutely no guarantee here. None whatsoever. 00:10:13.850 --> 00:10:17.929 The biggest risk is volatility. Prices fluctuate, 00:10:17.950 --> 00:10:20.470 sometimes wildly, based on news, on economic 00:10:20.470 --> 00:10:24.470 data, on investor sentiment. Fear and greed. 00:10:24.730 --> 00:10:26.970 Fear and greed. The source specifically highlights 00:10:26.970 --> 00:10:30.509 value stocks. These are often established dividend 00:10:30.509 --> 00:10:32.370 paying companies that maybe aren't growing super 00:10:32.370 --> 00:10:35.110 fast as facing uncertainty in future earnings. 00:10:35.450 --> 00:10:38.090 If a company has a bad year, what's the first 00:10:38.090 --> 00:10:40.700 thing they can do to save cash? Cut the dividend. 00:10:40.860 --> 00:10:43.559 Cut that dividend to zero. And suddenly your 00:10:43.559 --> 00:10:46.159 income stream is gone. So this profile is for 00:10:46.159 --> 00:10:48.200 the risk tolerant. If you're going to lose sleep 00:10:48.200 --> 00:10:50.600 because your portfolio is down 5 % one week, 00:10:50.659 --> 00:10:52.759 this isn't passive for you. It's just stress. 00:10:53.019 --> 00:10:55.960 Exactly. Emotional labor is still labor. If it 00:10:55.960 --> 00:10:57.960 costs you your peace of mind, it's not passive. 00:10:58.299 --> 00:11:01.740 Okay. Let's move to the third lane. Bonds. I 00:11:01.740 --> 00:11:03.559 feel like bonds are the thing everyone knows 00:11:03.559 --> 00:11:05.500 they should understand, but almost nobody actually 00:11:05.500 --> 00:11:08.080 does. It's true. They're sort of the sensible, 00:11:08.240 --> 00:11:11.659 boring cousin of stocks. But understanding them 00:11:11.659 --> 00:11:16.039 is key. Bonds are the lending route. So when 00:11:16.039 --> 00:11:18.059 you buy a stock, you're an owner. When you buy 00:11:18.059 --> 00:11:20.899 a bond, you are a lender. You become the bank. 00:11:21.039 --> 00:11:22.940 You are the bank. You are loaning your money 00:11:22.940 --> 00:11:25.940 to a government or a city or a big corporation. 00:11:26.500 --> 00:11:28.399 And the sources say understanding the mechanics 00:11:28.399 --> 00:11:30.440 here is really important because it explains 00:11:30.440 --> 00:11:33.700 the risk profile. It does. A bond has a few key 00:11:33.700 --> 00:11:35.860 components you need to know. There's the issue 00:11:35.860 --> 00:11:38.740 price, which is what you pay. There's the face 00:11:38.740 --> 00:11:41.059 value, which is what it's worth at the end. There's 00:11:41.059 --> 00:11:44.019 the coupon rate, which is your interest, and 00:11:44.019 --> 00:11:45.840 the maturity date, which is when you get paid 00:11:45.840 --> 00:11:49.179 back. Okay, stop right there. Coupon rate. I 00:11:49.179 --> 00:11:51.000 love this term because it feels so incredibly 00:11:51.000 --> 00:11:53.759 old -fashioned. Why do we call it a coupon? It's 00:11:53.759 --> 00:11:55.659 a great bit of financial history. It's because 00:11:55.659 --> 00:11:58.200 before everything was electronic, bonds were 00:11:58.200 --> 00:12:01.320 these beautiful, ornate, physical certificates. 00:12:02.819 --> 00:12:05.240 Like a stock certificate you see in old movies. 00:12:05.399 --> 00:12:07.820 Yeah, exactly like that. And at the bottom of 00:12:07.820 --> 00:12:10.519 the certificate, they had literal tear off coupons. 00:12:10.779 --> 00:12:13.460 Each one had a date on it. If your bond paid 00:12:13.460 --> 00:12:15.200 interest every six months, you would take a pair 00:12:15.200 --> 00:12:18.250 of scissors. Clip the coupon for that date, walk 00:12:18.250 --> 00:12:20.750 into a bank, and hand it to the teller. No way. 00:12:20.850 --> 00:12:22.730 And they'd just give you cash. They'd give you 00:12:22.730 --> 00:12:25.409 your interest payment. That is why we still talk 00:12:25.409 --> 00:12:27.850 about coupon clipping as a slang term for living 00:12:27.850 --> 00:12:30.629 off investments. It comes from a literal, physical 00:12:30.629 --> 00:12:33.970 act. That's amazing. So the income stream is 00:12:33.970 --> 00:12:37.409 this. I buy the bond, I get my regular coupon 00:12:37.409 --> 00:12:39.909 payments, and then at the very end, the maturity 00:12:39.909 --> 00:12:43.350 date, I get my original loan amount back. Ideally, 00:12:43.350 --> 00:12:45.870 yes. That's the plan. The main risk there is 00:12:45.870 --> 00:12:48.110 if the borrower goes bankrupt. If the company 00:12:48.110 --> 00:12:50.549 you lent money to goes under, you might get pennies 00:12:50.549 --> 00:12:52.669 on the dollar or nothing at all. But there's 00:12:52.669 --> 00:12:54.830 a twist here, according to the sources regarding 00:12:54.830 --> 00:12:57.029 resale, because you don't have to hold it until 00:12:57.029 --> 00:12:59.210 the very end. This is the part that confuses 00:12:59.210 --> 00:13:02.009 people, but it's where the other major risk comes 00:13:02.009 --> 00:13:05.330 in. You can sell a bond on the secondary market, 00:13:05.470 --> 00:13:08.490 just like a stock, and the price of that bond 00:13:08.490 --> 00:13:11.129 fluctuates based on what's happening with interest 00:13:11.129 --> 00:13:13.210 rates in the wider world. OK, walk us through 00:13:13.210 --> 00:13:15.370 that. Give me an example. OK, let's say you buy 00:13:15.370 --> 00:13:17.970 a 10 -year government bond today that pays 5 00:13:17.970 --> 00:13:20.789 % interest. It's a great deal. But a year from 00:13:20.789 --> 00:13:23.289 now, the Federal Reserve raises interest rates 00:13:23.289 --> 00:13:26.289 to fight inflation, and new bonds are being issued 00:13:26.289 --> 00:13:29.399 that pay 7%. Suddenly, nobody wants my old 5 00:13:29.399 --> 00:13:32.299 % bond anymore. Exactly. Why would they buy your 00:13:32.299 --> 00:13:35.659 5 % bond when they can get a brand new 7 % one? 00:13:35.820 --> 00:13:38.820 It's trash compared to the new stuff. So if you 00:13:38.820 --> 00:13:41.100 want to sell it before it matures, you have to 00:13:41.100 --> 00:13:42.620 sell it at a discount. You lose money on the 00:13:42.620 --> 00:13:45.120 principal. But the reverse is also true. The 00:13:45.120 --> 00:13:47.399 reverse is also true. Say you buy that bond at 00:13:47.399 --> 00:13:50.200 5 % and then the economy tanks and the Fed drops 00:13:50.200 --> 00:13:53.840 interest rates to 2%. My 5 % bond is now a gold 00:13:53.840 --> 00:13:56.789 mine. It's a golden goose. It's paying way more 00:13:56.789 --> 00:13:59.090 than anything else on the market. So you can 00:13:59.090 --> 00:14:01.429 sell it for a premium for more than you paid 00:14:01.429 --> 00:14:04.529 for it. That's why bonds, while generally safer 00:14:04.529 --> 00:14:07.529 and less volatile than stocks, still carry interest 00:14:07.529 --> 00:14:10.389 rate risk. OK, so we've covered deposits, stocks 00:14:10.389 --> 00:14:13.690 and bonds, the big three. But there's one more 00:14:13.690 --> 00:14:15.629 category in this section that I found really 00:14:15.629 --> 00:14:17.090 interesting because it sounds like something 00:14:17.090 --> 00:14:19.649 out of a gangster movie. Silent partnerships. 00:14:19.889 --> 00:14:23.159 It does sound dramatic, doesn't it? But. It's 00:14:23.159 --> 00:14:25.240 a very legitimate and actually pretty common 00:14:25.240 --> 00:14:28.580 business structure. A silent partner is an individual 00:14:28.580 --> 00:14:31.179 whose participation in a business is limited 00:14:31.179 --> 00:14:33.519 strictly to providing capital. They're the money 00:14:33.519 --> 00:14:35.580 guy, the bankroll. They are the bankroll. And 00:14:35.580 --> 00:14:38.919 crucially, to qualify as a silent partner in 00:14:38.919 --> 00:14:41.620 the eyes of the law and the IRS, they play no 00:14:41.620 --> 00:14:44.000 role in the day -to -day management of the business. 00:14:44.419 --> 00:14:46.519 So I can't just walk into the restaurant I invested 00:14:46.519 --> 00:14:48.909 in and tell the chef to change the menu. You 00:14:48.909 --> 00:14:51.570 cannot. You can't hire. You can't fire. You can't 00:14:51.570 --> 00:14:53.730 make strategy decisions. If you start doing that, 00:14:53.809 --> 00:14:55.970 you're no longer a silent partner. You're just 00:14:55.970 --> 00:14:58.649 a partner and you lose your special status and 00:14:58.649 --> 00:15:00.789 usually your liability protection. So because 00:15:00.789 --> 00:15:03.730 you're purely providing capital, the income you 00:15:03.730 --> 00:15:06.149 receive, which is an agreed upon percentage of 00:15:06.149 --> 00:15:09.309 the gross profits, is considered passive. This 00:15:09.309 --> 00:15:12.070 feels like one of the purest forms of passive 00:15:12.070 --> 00:15:14.389 income we've discussed because it's explicitly 00:15:14.389 --> 00:15:17.190 defined by the absence of labor. You are being 00:15:17.190 --> 00:15:19.830 paid for taking a financial risk, not for doing 00:15:19.830 --> 00:15:22.409 any work. Exactly. All right. Let's shift gears 00:15:22.409 --> 00:15:24.590 a bit. We're leaving the world of paper assets 00:15:24.590 --> 00:15:27.250 and moving into the physical world. Bricks and 00:15:27.250 --> 00:15:30.809 mortar, section two, the improperty of real estate. 00:15:31.179 --> 00:15:33.340 This is the classic path, right? When people 00:15:33.340 --> 00:15:35.379 think financial independence, they usually think 00:15:35.379 --> 00:15:37.620 of a portfolio of rental properties. For sure. 00:15:37.860 --> 00:15:41.000 Buy a duplex, rent out one half, have the tenant 00:15:41.000 --> 00:15:42.779 pay your mortgage while you live in the other. 00:15:42.940 --> 00:15:46.399 It's the quintessential dream. It is. But the 00:15:46.399 --> 00:15:48.480 source material took us down a really fascinating 00:15:48.480 --> 00:15:51.460 rabbit hole here with a term I had never, ever 00:15:51.460 --> 00:15:55.580 heard before. Improperty. Yes. This comes from 00:15:55.580 --> 00:15:58.240 the economist J .A. Hobson, and he was writing 00:15:58.240 --> 00:16:01.370 back in the 1930s. It's a concept that I really 00:16:01.370 --> 00:16:03.370 wish was taught more in Economics 101 because 00:16:03.370 --> 00:16:06.090 it reframes the whole conversation. So what is 00:16:06.090 --> 00:16:08.629 improperty? Break it down for us. Hobson was 00:16:08.629 --> 00:16:10.690 trying to make a critical distinction between 00:16:10.690 --> 00:16:13.950 property that you use to create value, like a 00:16:13.950 --> 00:16:17.429 hammer or a workshop or even your own home that 00:16:17.429 --> 00:16:22.049 you live in, and improperty. Improperty, in his 00:16:22.049 --> 00:16:24.870 view, is asset ownership used specifically for 00:16:24.870 --> 00:16:27.649 the purpose of extracting income from other individuals. 00:16:28.250 --> 00:16:30.529 Extracting is a very loaded word. It was meant 00:16:30.529 --> 00:16:33.429 to be. He was launching a critique of the philosophical 00:16:33.429 --> 00:16:37.169 underpinnings of landlordism. His argument basically 00:16:37.169 --> 00:16:39.509 is that if I'm a carpenter and I build a chair, 00:16:39.669 --> 00:16:42.409 I have created new value in the world. A chair 00:16:42.409 --> 00:16:44.789 exists that didn't exist before. Right. But if 00:16:44.789 --> 00:16:47.110 I own a plot of land and I just charge you rent 00:16:47.110 --> 00:16:49.529 to stand on it, I haven't actually created anything 00:16:49.529 --> 00:16:51.860 new. I am just charging you for access to something 00:16:51.860 --> 00:16:54.279 that already exists. I am extracting wealth from 00:16:54.279 --> 00:16:56.379 your labor simply because I hold the deed. It 00:16:56.379 --> 00:16:58.620 connects to that old idea of economic rent, doesn't 00:16:58.620 --> 00:17:01.159 it? The idea of unearned value. It does, very 00:17:01.159 --> 00:17:03.620 closely. It's the idea of unearned increments 00:17:03.620 --> 00:17:07.019 of value. But philosophy aside for a moment, 00:17:07.140 --> 00:17:09.539 this tension is what makes real estate such a 00:17:09.539 --> 00:17:12.380 polarizing topic in our society. Yeah. It's incredibly 00:17:12.380 --> 00:17:15.079 lucrative for the owner, but it is often viewed 00:17:15.079 --> 00:17:17.720 as parasitic by the tenant. Well, let's get into 00:17:17.720 --> 00:17:19.660 the mechanics of it, because regardless of the 00:17:19.660 --> 00:17:22.500 philosophy, people do it every day. The basics 00:17:22.500 --> 00:17:26.319 of rental income. Tenants pay you rent. Or maybe 00:17:26.319 --> 00:17:28.799 companies pay you royalties for using your land 00:17:28.799 --> 00:17:31.920 for, say, a cell tower. The pros are pretty obvious. 00:17:32.119 --> 00:17:34.259 It can be a very steady stream of cash flow. 00:17:34.440 --> 00:17:36.759 It offers the potential for appreciation. The 00:17:36.759 --> 00:17:39.059 building itself gets more valuable over time. 00:17:39.299 --> 00:17:41.859 And unlike stocks, you have a high degree of 00:17:41.859 --> 00:17:44.200 control over the asset. What do you mean by control? 00:17:44.420 --> 00:17:46.319 You can renovate the kitchen. You can add a deck. 00:17:46.420 --> 00:17:48.200 You can improve the landscaping. You can actively 00:17:48.200 --> 00:17:51.279 force the value of your asset to go up. You can't 00:17:51.279 --> 00:17:53.140 call up the CEO of Apple and tell him how to 00:17:53.140 --> 00:17:56.019 design the next iPhone. A very good point. But 00:17:56.019 --> 00:17:58.240 then there are the cons, starting with the high 00:17:58.240 --> 00:18:01.140 initial investment cost. You can't buy a house 00:18:01.140 --> 00:18:03.519 for $50 like you can a stock. Not unless you're 00:18:03.519 --> 00:18:05.920 in a very specific market. And then there's the 00:18:05.920 --> 00:18:07.519 biggest debate of all, the one that ties back 00:18:07.519 --> 00:18:10.839 to our core theme. Is it actually passive? This 00:18:10.839 --> 00:18:13.160 is the reality check. The source distinction 00:18:13.160 --> 00:18:16.359 here is sharp. It says rental income is only 00:18:16.359 --> 00:18:18.799 passive if it hasn't turned into an everyday 00:18:18.799 --> 00:18:21.190 job. And anyone who has ever been a landlord 00:18:21.190 --> 00:18:24.009 knows this struggle intimately. The managerial 00:18:24.009 --> 00:18:26.849 duties. Finding tenants, screening them, running 00:18:26.849 --> 00:18:28.930 credit checks, collecting the rent, which can 00:18:28.930 --> 00:18:31.269 be a nightmare. Dealing with noise complaints 00:18:31.269 --> 00:18:33.990 at 10 p .m. on a Tuesday. And, of course, the 00:18:33.990 --> 00:18:36.609 dreaded 3 a .m. phone call that the water heater 00:18:36.609 --> 00:18:39.130 has exploded and is flooding the downstairs apartment. 00:18:39.549 --> 00:18:41.509 Right. If I am the one driving over there with 00:18:41.509 --> 00:18:44.369 a wrench at 3 in the morning, that is not passive 00:18:44.369 --> 00:18:47.170 income. That is a very stressful, very low -paying 00:18:47.170 --> 00:18:50.009 job as a crisis manager. Exactly. That is labor. 00:18:50.410 --> 00:18:53.430 So to make it truly passive, you have to use 00:18:53.430 --> 00:18:56.049 what the industry calls the outsourcing loophole. 00:18:56.190 --> 00:18:58.230 Which means you hire a property manager. You 00:18:58.230 --> 00:19:01.670 hire a leasing agent. You pay someone else, usually 00:19:01.670 --> 00:19:04.430 10 % to 12 % of the gross monthly rent, to handle 00:19:04.430 --> 00:19:06.490 all the headaches. They take the 3 a .m. phone 00:19:06.490 --> 00:19:09.230 call. But that changes the math completely. It 00:19:09.230 --> 00:19:12.259 changes the math drastically. Now, that rent 00:19:12.259 --> 00:19:14.400 check you receive has to cover the mortgage, 00:19:14.640 --> 00:19:17.720 the insurance, the property taxes, a fund for 00:19:17.720 --> 00:19:21.559 future maintenance, and the management fee. If 00:19:21.559 --> 00:19:23.960 there is still profit left over after all of 00:19:23.960 --> 00:19:26.380 that... Then you have passive income. Then and 00:19:26.380 --> 00:19:29.420 only then. It seems like the profit margins are 00:19:29.420 --> 00:19:31.839 much, much thinner than people realize if they 00:19:31.839 --> 00:19:35.079 want true hands -off passivity. It sounds like 00:19:35.079 --> 00:19:37.359 many passive real estate investors are actually 00:19:37.359 --> 00:19:39.660 just buying themselves a part -time job as a 00:19:39.660 --> 00:19:41.819 janitor and bookkeeper. That's a very accurate 00:19:41.819 --> 00:19:43.940 way to put it. Now, before we leave this section 00:19:43.940 --> 00:19:46.799 on property, we should touch on royalties. The 00:19:46.799 --> 00:19:49.279 sources group this with real estate because it's 00:19:49.279 --> 00:19:51.880 about payment for the use of an asset. But instead 00:19:51.880 --> 00:19:54.630 of a physical house, it's an idea. intellectual 00:19:54.630 --> 00:19:57.690 property things like books music patents trademarks 00:19:57.690 --> 00:20:00.910 an idea that you own but the irs has a very specific 00:20:00.910 --> 00:20:02.950 and interesting caveat here they do they have 00:20:02.950 --> 00:20:05.069 to draw a line somewhere they say royalties are 00:20:05.069 --> 00:20:07.130 only considered passive income if they are not 00:20:07.130 --> 00:20:09.369 derived in the ordinary course of a trade or 00:20:09.369 --> 00:20:11.589 business okay can you give me an example of that 00:20:11.589 --> 00:20:14.630 that sounds a little abstract sure think of a 00:20:14.630 --> 00:20:17.730 famous author like stephen king he writes books 00:20:17.730 --> 00:20:21.730 that is his job That is his trade. The royalties 00:20:21.730 --> 00:20:24.150 he gets from his publisher for The Shining are 00:20:24.150 --> 00:20:27.329 considered active income. Why? Because he is 00:20:27.329 --> 00:20:28.869 in the business of writing books. That's what 00:20:28.869 --> 00:20:30.930 he does. It's the ordinary course of his business. 00:20:31.309 --> 00:20:33.430 Okay, that makes sense. So what's an example 00:20:33.430 --> 00:20:36.509 of passive royalty income? Okay, imagine a dentist. 00:20:37.049 --> 00:20:39.990 She works on teeth all day long. That's her business. 00:20:40.670 --> 00:20:43.450 But one weekend, she's tinkering in her garage, 00:20:43.690 --> 00:20:46.670 and she invents a new, more ergonomic handle 00:20:46.670 --> 00:20:49.890 for a dental mirror. She patents it. She then 00:20:49.890 --> 00:20:52.170 licenses that patent to a big medical supply 00:20:52.170 --> 00:20:54.589 manufacturer. Then she goes back to her normal 00:20:54.589 --> 00:20:57.269 job of fixing teeth. And the royalty checks for 00:20:57.269 --> 00:20:59.509 her invention start rolling in. Those checks 00:20:59.509 --> 00:21:01.349 would almost certainly be considered passive 00:21:01.349 --> 00:21:03.970 income by the IRS. She is not a professional 00:21:03.970 --> 00:21:06.609 inventor. It was not in her ordinary course of 00:21:06.609 --> 00:21:09.450 business. The income is derived from her ownership 00:21:09.450 --> 00:21:12.109 of the patent, not from her daily labor as a 00:21:12.109 --> 00:21:15.200 dentist. That is a fascinating distinction. It's 00:21:15.200 --> 00:21:17.259 that separation again between the creator and 00:21:17.259 --> 00:21:19.319 the owner. It is. And that actually leads us 00:21:19.319 --> 00:21:21.619 perfectly into our next section, section three, 00:21:21.720 --> 00:21:25.400 because the line between creator and owner is 00:21:25.400 --> 00:21:27.720 getting really, really blurry in the digital 00:21:27.720 --> 00:21:30.579 age. The gray area, what the source material 00:21:30.579 --> 00:21:33.619 calls leveraged income. This is the stuff that 00:21:33.619 --> 00:21:35.720 absolutely dominates your social media feed. 00:21:35.880 --> 00:21:39.460 E -books, video courses, software as a service, 00:21:39.680 --> 00:21:42.900 digital templates. I feel like every single person 00:21:42.900 --> 00:21:46.339 I know has a side hustle trying to sell a PDF 00:21:46.339 --> 00:21:48.660 template for something. And the source defines 00:21:48.660 --> 00:21:51.180 this not as passive income, strictly speaking, 00:21:51.339 --> 00:21:53.680 but as leveraged income. And the difference in 00:21:53.680 --> 00:21:55.900 terminology is important. OK, what is the difference? 00:21:56.160 --> 00:21:58.759 Passive income implies the asset itself does 00:21:58.759 --> 00:22:01.000 all the earning. A stock dividend, for example. 00:22:01.809 --> 00:22:03.930 Leveraged income, on the other hand, acknowledges 00:22:03.930 --> 00:22:05.970 that you have to put in a massive amount of active 00:22:05.970 --> 00:22:08.269 labor once to create a product that can then 00:22:08.269 --> 00:22:11.210 be sold theoretically indefinitely. So if I write 00:22:11.210 --> 00:22:13.910 an e -book on, I don't know, gardening, I might 00:22:13.910 --> 00:22:16.109 spend 200 hours writing and editing it. That 00:22:16.109 --> 00:22:19.809 is very active work. Huge active work. And it's 00:22:19.809 --> 00:22:21.470 unpaid active work at that point. You're working 00:22:21.470 --> 00:22:24.750 entirely on spec. But once that digital file 00:22:24.750 --> 00:22:27.500 is created and uploaded to the server. The cost 00:22:27.500 --> 00:22:29.980 to sell it to one person is essentially the same 00:22:29.980 --> 00:22:32.579 as the cost to sell it to a million people. Zero 00:22:32.579 --> 00:22:35.420 marginal cost of reproduction. That is the magic 00:22:35.420 --> 00:22:37.980 of digital products. If you make physical chairs 00:22:37.980 --> 00:22:40.559 and you want to sell 100 more chairs, you need 00:22:40.559 --> 00:22:43.519 more wood, more glue and more hours from a carpenter. 00:22:43.619 --> 00:22:45.920 Right. If you want to sell 100 more copies of 00:22:45.920 --> 00:22:48.259 your digital course on gardening, you just need 00:22:48.259 --> 00:22:51.500 a slightly better server hosting plan. The leverage 00:22:51.500 --> 00:22:54.519 is immense. And that scalability is why it's 00:22:54.519 --> 00:22:57.240 so easily confused with passive. Because after 00:22:57.240 --> 00:23:00.059 the launch, after the hard work is done, it feels 00:23:00.059 --> 00:23:02.000 passive. The sales come in while you're sleeping. 00:23:02.160 --> 00:23:04.319 It feels passive because the labor is decoupled 00:23:04.319 --> 00:23:06.119 from the individual transaction. You don't have 00:23:06.119 --> 00:23:08.119 to be there physically or digitally when the 00:23:08.119 --> 00:23:10.240 customer clicks buy. But the source material 00:23:10.240 --> 00:23:12.720 warns us about a massive cognitive bias here. 00:23:12.799 --> 00:23:15.990 The survivorship bias. Oh, it's huge in this 00:23:15.990 --> 00:23:18.950 space. We only ever see the winners. We see the 00:23:18.950 --> 00:23:20.910 one guy who made a million dollars selling a 00:23:20.910 --> 00:23:23.450 course on how to make the perfect toast. We don't 00:23:23.450 --> 00:23:26.210 see the 10 ,000 other people who spent six months 00:23:26.210 --> 00:23:28.730 of their lives making a course that sold three 00:23:28.730 --> 00:23:30.890 copies, two of which were to their parents. So 00:23:30.890 --> 00:23:34.349 it's extremely high risk, high reward. It's almost 00:23:34.349 --> 00:23:36.170 like a lottery ticket that you buy with your 00:23:36.170 --> 00:23:38.269 time and debt of your money. That is a great 00:23:38.269 --> 00:23:40.210 way to put it. The potential payoff is huge, 00:23:40.309 --> 00:23:43.289 but the odds of success are very, very long. 00:23:43.849 --> 00:23:46.049 Okay, we've covered the fun stuff, the dreams, 00:23:46.289 --> 00:23:49.069 the different ways to make this happen. Now we 00:23:49.069 --> 00:23:51.430 have to put on our suits and talk to the reality 00:23:51.430 --> 00:23:56.309 police. Section 4, the IRS and the taxman. This 00:23:56.309 --> 00:23:59.019 is where the rubber truly meets the road. If 00:23:59.019 --> 00:24:01.720 you are in the United States, the IRS has a very, 00:24:01.759 --> 00:24:04.279 very strict set of rules for what counts, and 00:24:04.279 --> 00:24:06.359 it often doesn't align with our intuition. We 00:24:06.359 --> 00:24:08.680 mentioned the buckets earlier, active, passive, 00:24:08.900 --> 00:24:11.680 portfolio. But we really need to dig into the 00:24:11.680 --> 00:24:14.920 wall that separates active and passive. The source 00:24:14.920 --> 00:24:17.819 keeps mentioning this phrase, material participation. 00:24:18.359 --> 00:24:21.430 This is the golden key. Material participation 00:24:21.430 --> 00:24:25.109 is the legal test the IRS uses to decide if you 00:24:25.109 --> 00:24:27.769 are an investor or if you are a worker in a particular 00:24:27.769 --> 00:24:30.509 activity. How do they measure it? Is it subjective? 00:24:31.210 --> 00:24:33.670 They try to make it as objective as possible, 00:24:33.829 --> 00:24:36.269 and it mostly comes down to hours. There are 00:24:36.269 --> 00:24:37.910 actually seven different tests you can meet, 00:24:37.970 --> 00:24:39.809 but the big one, the one most people talk about, 00:24:39.890 --> 00:24:42.849 is the 500 -hour rule. The 500 -hour rule. Right. 00:24:42.930 --> 00:24:45.529 If you spend more than 500 hours a year on a 00:24:45.529 --> 00:24:48.509 business activity, the IRS generally says, congratulations, 00:24:48.930 --> 00:24:51.609 you are materially participating. This is active 00:24:51.609 --> 00:24:54.690 income, not passive. So if I work too hard on 00:24:54.690 --> 00:24:56.589 my side hustle, I can accidentally make it active 00:24:56.589 --> 00:24:59.220 in the eyes of the IRS. Yes, exactly. And that 00:24:59.220 --> 00:25:01.359 can be good or bad, depending on your situation. 00:25:01.619 --> 00:25:04.339 It matters because, generally speaking, people 00:25:04.339 --> 00:25:07.079 sometimes want income to be classified as passive 00:25:07.079 --> 00:25:09.839 so they can offset it with other passive losses. 00:25:09.980 --> 00:25:12.660 Oh, for the tax strategy. Right. But other times 00:25:12.660 --> 00:25:14.619 you might want it to be active. For example, 00:25:14.619 --> 00:25:16.880 you can't contribute to certain retirement plans 00:25:16.880 --> 00:25:19.599 like a 401k from passive income. It has to be 00:25:19.599 --> 00:25:23.059 earned active income. So the classification changes 00:25:23.059 --> 00:25:25.900 your entire financial strategy. OK, let's circle 00:25:25.900 --> 00:25:28.099 back to real estate for a minute. But the IRS 00:25:28.099 --> 00:25:31.619 rules here are wildly specific. I was reading 00:25:31.619 --> 00:25:33.779 through the source notes on what they call the 00:25:33.779 --> 00:25:36.019 hotel exceptions, and it felt like I was doing 00:25:36.019 --> 00:25:38.240 logic puzzles. It's designed to stop people from 00:25:38.240 --> 00:25:41.180 gaming the system. The IRS needs to draw a clear 00:25:41.180 --> 00:25:43.759 line. Are you a landlord, which is a passive 00:25:43.759 --> 00:25:46.420 activity, or are you running a hotel, which is 00:25:46.420 --> 00:25:48.359 a service business? So let's start with rule 00:25:48.359 --> 00:25:51.269 number one, the seven days or less rule. This 00:25:51.269 --> 00:25:54.410 one is huge for the Airbnb generation. The IRS 00:25:54.410 --> 00:25:56.750 says that if the average period of customer use 00:25:56.750 --> 00:25:59.250 for your property is seven days or less, it is 00:25:59.250 --> 00:26:01.619 not a rental activity. Wait wait. If it's not 00:26:01.619 --> 00:26:04.180 a rental activity, what is it? It's a trade or 00:26:04.180 --> 00:26:06.599 business, like a hotel. So all those people renting 00:26:06.599 --> 00:26:08.559 out their beach condos for the weekend. If their 00:26:08.559 --> 00:26:10.940 average stay is short, they aren't passive real 00:26:10.940 --> 00:26:13.299 estate investors in the eyes of the IRS. They 00:26:13.299 --> 00:26:16.259 are active business owners. And this has a massive 00:26:16.259 --> 00:26:18.720 tax implication. Which is? It means the income 00:26:18.720 --> 00:26:21.400 might be subject to self -employment tax. That's 00:26:21.400 --> 00:26:23.759 Social Security and Medicare tax, which is an 00:26:23.759 --> 00:26:27.740 extra 15 .3 % tax hit that a normal, passive 00:26:27.740 --> 00:26:31.089 landlord doesn't have to pay. Ouch. That is a 00:26:31.089 --> 00:26:33.029 nasty surprise if you're not expecting it. A 00:26:33.029 --> 00:26:35.710 very nasty surprise. Then you have the next rule, 00:26:35.849 --> 00:26:39.150 the significant personal services rule. This 00:26:39.150 --> 00:26:41.910 one applies if the average stay is 30 days or 00:26:41.910 --> 00:26:44.430 less. So like a midterm rental for a traveling 00:26:44.430 --> 00:26:47.450 nurse or something. Exactly. The rule says if 00:26:47.450 --> 00:26:50.329 you rent for 30 days or less and you provide 00:26:50.329 --> 00:26:53.789 significant personal services, it's not a rental. 00:26:54.279 --> 00:26:57.440 It's a business. Okay. What counts as a significant 00:26:57.440 --> 00:27:00.880 service? Is cleaning the place between tenants 00:27:00.880 --> 00:27:04.259 significant? No. Things like cleaning the common 00:27:04.259 --> 00:27:06.619 areas or fixing the roof don't count. That's 00:27:06.619 --> 00:27:08.440 just considered normal for being a landlord. 00:27:08.700 --> 00:27:11.079 But if you are changing the linens every day, 00:27:11.180 --> 00:27:13.319 providing breakfast, offering guided tours of 00:27:13.319 --> 00:27:15.180 the city, or providing room service. They're 00:27:15.180 --> 00:27:16.759 not a landlord anymore. You're a bed and breakfast. 00:27:16.920 --> 00:27:19.160 You're a business, not a passive investment. 00:27:19.220 --> 00:27:21.640 And again, subject to that self -employment tax. 00:27:21.980 --> 00:27:23.500 There was one more exception in the notes that 00:27:23.500 --> 00:27:24.880 I had. thought was really niche but interesting. 00:27:25.039 --> 00:27:28.220 The extraordinary personal services rule. This 00:27:28.220 --> 00:27:30.579 covers things where the rental is incidental 00:27:30.579 --> 00:27:33.460 to the service. Think about a hospital or a college 00:27:33.460 --> 00:27:35.940 dorm. Technically, when you're in a hospital, 00:27:36.200 --> 00:27:39.099 you are paying for the use of the room. But the 00:27:39.099 --> 00:27:42.500 IRS says, no, the real value here is the doctors, 00:27:42.619 --> 00:27:46.259 the nurses, the medical care. The room is incidental 00:27:46.259 --> 00:27:49.259 to the service. So a hospital cannot claim its 00:27:49.259 --> 00:27:52.680 room fees as passive rental income. That makes 00:27:52.680 --> 00:27:55.339 perfect sense. It's logically consistent, even 00:27:55.339 --> 00:27:57.539 if it's complicated. Now, I want to talk about 00:27:57.539 --> 00:27:59.640 a specific loophole that the source material 00:27:59.640 --> 00:28:02.220 flagged. It's called self -charged interest. 00:28:02.660 --> 00:28:06.259 Ah, yes. This is financial inception. It gets 00:28:06.259 --> 00:28:08.099 a little weird. It sounds like I'm lending money 00:28:08.099 --> 00:28:10.279 to myself and paying myself interest. Effectively, 00:28:10.279 --> 00:28:12.920 you are. Let's set up a scenario. Say you own 00:28:12.920 --> 00:28:15.380 an S corporation. You are the sole owner. The 00:28:15.380 --> 00:28:17.680 business needs a cash infusion. Instead of going 00:28:17.680 --> 00:28:20.720 to a bank, you, the individual, lend the business 00:28:20.720 --> 00:28:23.420 $100 ,000 from your personal savings. Okay, so 00:28:23.420 --> 00:28:26.160 the business now owes me, the person, money. 00:28:26.299 --> 00:28:28.079 And the business pays you interest on that loan, 00:28:28.160 --> 00:28:30.960 let's say 5 % a year. Now, normally, where does 00:28:30.960 --> 00:28:33.559 interest income go? Into that third bucket, portfolio 00:28:33.559 --> 00:28:36.670 income. Right. But the self -charged interest 00:28:36.670 --> 00:28:39.289 rule says that if the business uses that borrowed 00:28:39.289 --> 00:28:43.109 money for a passive activity, say, buying a rental 00:28:43.109 --> 00:28:44.930 property that you don't materially participate 00:28:44.930 --> 00:28:48.109 in, then the IRS allows you to recharacterize 00:28:48.109 --> 00:28:50.430 the interest income you receive. You can treat 00:28:50.430 --> 00:28:52.410 it as passive income. Why on earth would I want 00:28:52.410 --> 00:28:54.319 to do that? Because of the buckets. It's all 00:28:54.319 --> 00:28:56.319 about the buckets. If you have other passive 00:28:56.319 --> 00:28:58.380 losses, maybe that rental property you bought 00:28:58.380 --> 00:29:00.599 is losing money on paper because of depreciation, 00:29:00.700 --> 00:29:03.359 you can now use those passive losses to offset 00:29:03.359 --> 00:29:05.700 this passive interest income. So I'm matching 00:29:05.700 --> 00:29:08.140 the income to the loss to zero out my tax bill 00:29:08.140 --> 00:29:10.039 on that interest. You've created a closed loop. 00:29:10.119 --> 00:29:12.400 It's an incredibly clever and perfectly legal 00:29:12.400 --> 00:29:15.079 tax planning strategy, but it's also incredibly 00:29:15.079 --> 00:29:18.250 complex. It is. And this leads us to the big 00:29:18.250 --> 00:29:20.990 critique in the source material. All of these 00:29:20.990 --> 00:29:23.930 rules, self -charged interest, material participation, 00:29:24.289 --> 00:29:26.890 depreciation, the hotel exceptions, they are 00:29:26.890 --> 00:29:29.910 ridiculously complicated. Who is this system 00:29:29.910 --> 00:29:32.500 actually built for? The wealthy. The sources 00:29:32.500 --> 00:29:34.940 are very, very blunt about this. High income 00:29:34.940 --> 00:29:37.559 groups use these complex passive income strategies 00:29:37.559 --> 00:29:40.259 for tax avoidance. Because they're the only ones 00:29:40.259 --> 00:29:42.940 who can afford the teams of accountants and lawyers 00:29:42.940 --> 00:29:45.319 to figure this stuff out. That's a huge part 00:29:45.319 --> 00:29:47.319 of it. But it's also that they have the capital 00:29:47.319 --> 00:29:49.220 to diversify into all these different areas. 00:29:49.400 --> 00:29:51.400 They have S -Corp, they have partnerships, they 00:29:51.400 --> 00:29:53.660 have stocks, they have real estate. They can 00:29:53.660 --> 00:29:56.319 structure their income to flow into the buckets 00:29:56.319 --> 00:29:59.200 that have the lowest tax rates. Meanwhile, the 00:29:59.200 --> 00:30:03.490 average middle class worker gets a... And the 00:30:03.490 --> 00:30:05.990 IRS knows exactly what they made, down to the 00:30:05.990 --> 00:30:09.109 penny. There is no hiding a paycheck. There is 00:30:09.109 --> 00:30:12.410 no structuring your salary to be a capital gain 00:30:12.410 --> 00:30:15.210 or to be offset by passive losses. This is what 00:30:15.210 --> 00:30:17.289 they call the wage tax argument. Exactly. The 00:30:17.289 --> 00:30:19.289 critics in our sources argue that the U .S. tax 00:30:19.289 --> 00:30:22.910 code, in practice, has degraded into a tax on 00:30:22.910 --> 00:30:25.630 wages. It primarily targets the working class 00:30:25.630 --> 00:30:27.849 and the middle class. If you work for a living, 00:30:27.990 --> 00:30:30.329 you pay high marginal rates. If you own things 00:30:30.329 --> 00:30:32.230 for a living... living, you pay much lower rates 00:30:32.230 --> 00:30:35.009 on capital gains or you use depreciation and 00:30:35.009 --> 00:30:37.250 other tricks to pay nothing at all. The stats 00:30:37.250 --> 00:30:39.309 in the source material seem to back this up. 00:30:39.349 --> 00:30:42.250 Says about 20 percent of Americans receive some 00:30:42.250 --> 00:30:45.109 form of passive income. But, and this is a huge, 00:30:45.250 --> 00:30:48.029 but for the vast majority of that 20%, it's peanuts. 00:30:48.730 --> 00:30:51.410 It's less than $5 ,000 a year. It's the interest 00:30:51.410 --> 00:30:54.170 from a small savings bond or a tiny dividend 00:30:54.170 --> 00:30:56.529 check from a few shares of stock. It's not the 00:30:56.529 --> 00:30:58.309 Bali lifestyle. It's not the Bali lifestyle. 00:30:58.450 --> 00:31:00.730 The number of people actually living the passive 00:31:00.730 --> 00:31:03.730 income lifestyle is statistically tiny. It is 00:31:03.730 --> 00:31:05.869 a game played at the very top of the economic 00:31:05.869 --> 00:31:09.509 pyramid. So that is the rather complicated view 00:31:09.509 --> 00:31:12.230 from the United States. But money is global. 00:31:12.940 --> 00:31:15.059 I want to zoom out for our last section, section 00:31:15.059 --> 00:31:18.839 five. How do other countries handle this? Is 00:31:18.839 --> 00:31:21.099 the U .S. unique in this system that seems to 00:31:21.099 --> 00:31:24.299 favor the owner over the worker? It varies quite 00:31:24.299 --> 00:31:26.599 a bit, but you see similar patterns. Let's start 00:31:26.599 --> 00:31:29.200 with Europe. Is there a unified European definition 00:31:29.200 --> 00:31:32.000 of passive income? No, not at all. This is a 00:31:32.000 --> 00:31:34.579 common misconception. The European Union is a 00:31:34.579 --> 00:31:36.700 political union, but it is not a fiscal one. 00:31:37.019 --> 00:31:40.900 The EU itself lacks direct taxation powers. So 00:31:40.900 --> 00:31:43.119 every country is on its own. Every country makes 00:31:43.119 --> 00:31:44.900 its own rules. France has different rules than 00:31:44.900 --> 00:31:46.819 Germany, which has different rules than Ireland, 00:31:47.019 --> 00:31:49.079 which is why so many tech companies are headquartered 00:31:49.079 --> 00:31:51.380 there for tax reasons. But there is some kind 00:31:51.380 --> 00:31:53.640 of standardization in reporting, right? To stop 00:31:53.640 --> 00:31:57.190 people from hiding money. Yes. The OECD, that's 00:31:57.190 --> 00:31:59.329 the Organization for Economic Cooperation and 00:31:59.329 --> 00:32:01.710 Development, introduced something called the 00:32:01.710 --> 00:32:05.170 Common Reporting Standard, or CRS. And what did 00:32:05.170 --> 00:32:08.049 that do? It basically provides a guideline list 00:32:08.049 --> 00:32:10.869 for financial institutions. It says, hey countries, 00:32:11.069 --> 00:32:13.470 you should generally consider dividends, interest, 00:32:13.869 --> 00:32:16.869 rents, annuities, and things like financial swaps 00:32:16.869 --> 00:32:19.700 as passive income. It's a way to get countries 00:32:19.700 --> 00:32:22.119 to share data with each other automatically to 00:32:22.119 --> 00:32:24.880 catch tax evaders, but it doesn't dictate the 00:32:24.880 --> 00:32:27.579 tax rate. For the rates, we have to look at specific 00:32:27.579 --> 00:32:30.400 countries. Let's go east and look at China. Their 00:32:30.400 --> 00:32:34.000 approach is stark. Very stark. China uses a flat 00:32:34.000 --> 00:32:37.319 tax for passive and unearned income. It is taxed 00:32:37.319 --> 00:32:41.140 at a proportional rate of 20%. 20%. Flat. Doesn't 00:32:41.140 --> 00:32:43.559 matter if I make 100 yuan or 100 million yuan 00:32:43.559 --> 00:32:47.160 for my investments. Correct. 20%. Now, contrast 00:32:47.160 --> 00:32:50.079 that with active income wages from a job. In 00:32:50.079 --> 00:32:53.000 China, that is subject to a progressive rate 00:32:53.000 --> 00:32:56.220 that goes all the way up to 45 % for high earners. 00:32:56.359 --> 00:32:58.319 Wow. Okay, so let me get this straight. If I 00:32:58.319 --> 00:33:00.599 work incredibly hard and become a top surgeon 00:33:00.599 --> 00:33:03.539 in China and earn a high salary, I give nearly 00:33:03.539 --> 00:33:06.460 half of it to the government. Correct. But if 00:33:06.460 --> 00:33:09.400 I just sit back and collect interest and dividends 00:33:09.400 --> 00:33:12.720 on my massive inheritance, I only give 20%. That 00:33:12.720 --> 00:33:15.069 is the math. And the source material explicitly 00:33:15.069 --> 00:33:18.589 critiques this. It calls this system horizontally 00:33:18.589 --> 00:33:21.750 unfair. Horizontal unfairness. Explain that term 00:33:21.750 --> 00:33:24.109 for us. Horizontal equity is a basic principle 00:33:24.109 --> 00:33:26.869 of taxation that says people with similar income 00:33:26.869 --> 00:33:29.509 levels should pay similar amounts of tax. Big 00:33:29.509 --> 00:33:31.890 sense. But in this system, two people could both 00:33:31.890 --> 00:33:35.190 make, say, the equivalent of $500 ,000. The surgeon 00:33:35.190 --> 00:33:37.549 pays a very high rate. The capital owner pays 00:33:37.549 --> 00:33:40.509 a much lower rate. Their tax burdens are wildly 00:33:40.509 --> 00:33:42.549 different, even though their income is the same. 00:33:43.069 --> 00:33:46.029 It is horizontally unfair. And the source argues 00:33:46.029 --> 00:33:49.490 this fails to regulate the income gap. It does 00:33:49.490 --> 00:33:52.569 the opposite. It exacerbates it. It explicitly 00:33:52.569 --> 00:33:56.089 favors capital owners over workers, which by 00:33:56.089 --> 00:33:58.390 its very nature accelerates wealth concentration 00:33:58.390 --> 00:34:00.890 at the top. OK, let's move north from there to 00:34:00.890 --> 00:34:04.509 Russia. They are famous for their flat tax. Yes, 00:34:04.609 --> 00:34:08.050 the 13 percent rule. For a long time, Russia 00:34:08.050 --> 00:34:11.190 had a flat 13 % tax on almost everything, which 00:34:11.190 --> 00:34:13.809 was a huge simplification of their old system. 00:34:14.090 --> 00:34:17.250 For passive income, taxes withheld on security 00:34:17.250 --> 00:34:20.510 sales if they're sold for a profit on bond coupons 00:34:20.510 --> 00:34:23.289 and on dividends. And they have a very specific 00:34:23.289 --> 00:34:26.349 formula for the calculation. Yes, it's very clear. 00:34:26.449 --> 00:34:29.070 It is sales amount minus any sales commissions 00:34:29.070 --> 00:34:31.030 minus the original purchase amount minus any 00:34:31.030 --> 00:34:33.889 purchase commissions times 13%. It's purely a 00:34:33.889 --> 00:34:35.829 tax on the net profit. What if I lose money? 00:34:35.880 --> 00:34:37.960 What if I sell my stock for less than I bought 00:34:37.960 --> 00:34:40.780 it for? If the asset loses value, no tax is paid. 00:34:40.940 --> 00:34:42.980 It's very straightforward. You only pay tax on 00:34:42.980 --> 00:34:45.780 your gains. And for non -residents, if I'm an 00:34:45.780 --> 00:34:47.880 American wanting to invest in the Russian market? 00:34:48.079 --> 00:34:49.800 The rules are slightly different. If you are 00:34:49.800 --> 00:34:51.719 an outsider investing in Russia, the dividend 00:34:51.719 --> 00:34:55.880 tax bumps up from 13 % to 15%. Okay. Finally, 00:34:56.059 --> 00:34:58.960 let's look at Kazakhstan. The source highlighted 00:34:58.960 --> 00:35:01.820 them as a really interesting outlier, using tax 00:35:01.820 --> 00:35:05.159 policy in a very aggressive way. Kazakhstan is 00:35:05.159 --> 00:35:07.900 essentially using its tax policy as a giant magnet 00:35:07.900 --> 00:35:10.559 for capital. Their base rate for dividends is 00:35:10.559 --> 00:35:14.440 an already low 5 % income tax. 5 % is incredibly 00:35:14.440 --> 00:35:17.179 low. That's lower than sales tax in those places. 00:35:17.400 --> 00:35:20.900 It is. But here is the real kicker. Dividends 00:35:20.900 --> 00:35:23.000 and capital gains on securities that are listed 00:35:23.000 --> 00:35:25.739 on the official Kazakh stock exchanges are often 00:35:25.739 --> 00:35:28.280 excluded from taxable passive income entirely. 00:35:28.739 --> 00:35:32.349 Excluded, you mean? 0 % tax? Tax -free. Zero. 00:35:32.389 --> 00:35:34.389 Why on earth would they do that? What's the strategy? 00:35:34.630 --> 00:35:37.010 The strategy is to encourage local investment. 00:35:37.230 --> 00:35:39.170 They are trying to build up their domestic capital 00:35:39.170 --> 00:35:41.489 markets. They want people, both local and foreign, 00:35:41.590 --> 00:35:43.969 to move their money into the Kazakh stock exchange. 00:35:44.210 --> 00:35:46.829 So they are effectively saying, if you come play 00:35:46.829 --> 00:35:49.550 in our sandbox, you get to play for free. That 00:35:49.550 --> 00:35:51.849 is one of the clearest examples of using a tax 00:35:51.849 --> 00:35:54.170 code for social or economic engineering I've 00:35:54.170 --> 00:35:56.300 ever heard. Absolutely. And it's a great reminder 00:35:56.300 --> 00:35:59.199 that tax codes are never neutral. They're never 00:35:59.199 --> 00:36:01.679 just about raising revenue. They always tell 00:36:01.679 --> 00:36:04.199 you what a society or at least its government 00:36:04.199 --> 00:36:06.880 values. And what do these examples tell us? They 00:36:06.880 --> 00:36:09.079 tell us that Kazakhstan values capital investment 00:36:09.079 --> 00:36:11.719 right now above all else. And they tell us that 00:36:11.719 --> 00:36:14.840 in their own ways, both China and the U .S. currently 00:36:14.840 --> 00:36:18.179 value capital ownership over labor. It's a pretty 00:36:18.179 --> 00:36:20.340 sobering realization when you lay it all out 00:36:20.340 --> 00:36:23.340 like that. It is. We have traveled a long, long 00:36:23.340 --> 00:36:26.360 way in this deep dive, from the safety of a bank 00:36:26.360 --> 00:36:28.739 vault to the volatility of the stock market, 00:36:28.900 --> 00:36:31.880 from the philosophical concept of improperty 00:36:31.880 --> 00:36:34.900 in the 1930s to the nitty -gritty of the IRS 00:36:34.900 --> 00:36:37.639 seven -day rule for Airbnbs. And all the way 00:36:37.639 --> 00:36:39.699 to the steps of Kazakhstan. It's been quite a 00:36:39.699 --> 00:36:41.920 journey. If we had to boil all this down for 00:36:41.920 --> 00:36:43.599 the listener, the one who started this episode, 00:36:43.739 --> 00:36:47.210 dreaming of that beach chair in Bali. What is 00:36:47.210 --> 00:36:49.429 the single biggest takeaway? I would say this. 00:36:49.789 --> 00:36:51.809 Passive income is real, but it's not a verb. 00:36:52.050 --> 00:36:54.690 It's a noun. It is not something you do. It is 00:36:54.690 --> 00:36:56.710 something you own. You don't passive income. 00:36:56.869 --> 00:36:59.860 You own assets that generate income. Exactly. 00:36:59.960 --> 00:37:02.639 And the transition from being a laborer, someone 00:37:02.639 --> 00:37:04.480 who trades their time for money, to being an 00:37:04.480 --> 00:37:06.539 owner, someone whose assets generate money for 00:37:06.539 --> 00:37:08.599 them, is the hardest financial lead anyone can 00:37:08.599 --> 00:37:11.179 make. It's a fundamental shift in your relationship 00:37:11.179 --> 00:37:13.780 with the economy. It requires sacrifice. It requires 00:37:13.780 --> 00:37:16.300 risk. And as we learned with that leveraged income 00:37:16.300 --> 00:37:19.320 section, it often requires a massive amount of 00:37:19.320 --> 00:37:22.360 unpaid active work just to get the engine started. 00:37:22.599 --> 00:37:24.539 And then if you're lucky enough to get there, 00:37:24.639 --> 00:37:27.039 you find yourself in a system that is, in many 00:37:27.039 --> 00:37:29.789 ways, designed to help you stay. there. The tax 00:37:29.789 --> 00:37:31.849 code becomes a map, but it's a map written in 00:37:31.849 --> 00:37:34.329 a language that heavily favors the owners. Which 00:37:34.329 --> 00:37:36.210 brings us right back around to that provocative 00:37:36.210 --> 00:37:39.210 thought from J .A. Hobson. Improperty. It's the 00:37:39.210 --> 00:37:41.110 question that really sticks with me from all 00:37:41.110 --> 00:37:44.389 of this. If our entire global economic system, 00:37:44.469 --> 00:37:47.269 from the supposedly capitalist U .S. to supposedly 00:37:47.269 --> 00:37:51.329 communist China, is wired to tax labor heavily 00:37:51.329 --> 00:37:55.170 and tax ownership lightly. What does that say 00:37:55.170 --> 00:37:58.210 about our collective values? Right. Are we implicitly 00:37:58.210 --> 00:38:00.389 saying that the person who holds the wealth is 00:38:00.389 --> 00:38:02.469 more valuable to society than the person who 00:38:02.469 --> 00:38:04.869 creates the wealth through their work? It's a 00:38:04.869 --> 00:38:08.969 profound question. Do we as a society value the 00:38:08.969 --> 00:38:12.730 past, which is what accumulated capital is, more 00:38:12.730 --> 00:38:15.150 than we value the present, which is active effort 00:38:15.150 --> 00:38:17.710 and labor? That is definitely something to chew 00:38:17.710 --> 00:38:19.489 on the next time you look at your pay stub or 00:38:19.489 --> 00:38:21.349 the next time you see one of those get rich sleeping 00:38:21.349 --> 00:38:24.789 ads online. That's it for this deep dive into 00:38:24.789 --> 00:38:27.309 passive income. We hope you feel a little smarter, 00:38:27.510 --> 00:38:29.789 maybe a little more cynical, and a lot better 00:38:29.789 --> 00:38:31.750 prepared to argue with your accountant. Thanks 00:38:31.750 --> 00:38:32.869 for listening. See you next time.