Welcome back to the Deep Dive. I want you to
picture something with me for a second. It's
an image I see probably 10 times a day. Oh, I
think I know where this is going. Yeah. I'm scrolling
through Instagram or maybe LinkedIn, and I see
a guy, and let's be honest, it is almost always
a guy. Right. He's sitting on some teak deck
in Bali. He's got a laptop open, but he's not
even looking at it. He's looking out at the ocean.
Of course. And the caption, it always says something
like, I made $5 ,000 while I slept last night.
Ask me how. It's the modern siren song, isn't
it? It is, I think, the most pervasive marketing
pitch of the last decade. It really is. The dream
of passive income. It feels like the holy grail
of modern economics, at least for the average
person. Right. We're not just being sold a financial
product. We're being sold an exit strategy. An
escape hatch. Exactly. The pitch is you can quit
the nine to five. You can stop trading your time
for money. And you just you build a machine that
prints cash forever. It's a beautiful dream.
I mean, frankly, who wouldn't want that? The
idea of decoupling your survival from your labor
is what it's the ultimate freedom is. But as
we so often find on these deep dives, when you
actually pull back the curtain and you look at
the, you know, the accounting manuals, the tax
codes, the actual economic theory, the reality
is. Well, it's a lot stickier than the Instagram
caption suggests. And that is exactly why we're
here today. Yeah. We're going to strip away all
of that influencer hype. We've got a stack of
sources here that includes everything from IRS
publications to these historical economic critiques
from the 1930s and even some global tax comparisons.
A pretty wide net. Our mission today is to figure
out what passive income actually is, not what
we wish it was, but what the law and the math
says it is. And that distinction is just so critical
because if you confuse the colloquial definition
of easy money with the legal definition of passive
income, you're not just setting yourself up for
disappointment. You are potentially setting yourself
up for a massive tax audit. And nobody wants
that. No, definitely not. So let's start at the
very bottom, the bedrock. Yeah. If we're looking
at the source material. How do we fundamentally
define passive income? Okay, so if we're being
really strict, looking at the economic and accounting
definitions, passive income is defined as unearned
income that is acquired with little to no labor
to earn or maintain it. Little to no labor. That
seems to be the operative phrase, doesn't it?
It is. And to really get it, you have to contrast
it with what, you know, the vast majority of
our listeners are doing right now to earn a living.
Which is earning active income. Earning active
income. The standard trade. I give you an hour
of my life. You give me a set amount of dollars.
Exactly. Wages, salaries, tips, commissions.
It doesn't matter if you're a high powered lawyer
billing a thousand dollars an hour. That is still
active income. Because if you stop showing up.
The money stops flowing. You are the engine.
With passive income, the whole goal is to build
a machine, step away from it, and have it keep
running on its own. Okay, so that seems simple
enough. Bucket A is work. Bucket B is not work.
But looking at our notes here, the IRS, they
throw a wrench in the gears right away. They
love to do that. They do. Because I think most
people, myself included, would probably say,
okay, I buy a stock, I get a dividend check,
that's passive income. But the tax man disagrees.
Yeah. This is probably the first and biggest
misconception we need to clear up. For the IRS,
it's not just two buckets. They have three. Three
buckets. Three buckets. So bucket one is your
active income. We just covered that. Bucket two
is passive income. But bucket three is what they
call portfolio income. Portfolio income. OK.
Right. And this bucket covers things like dividends,
interest and capital gains. So strictly speaking,
when you buy a share of Apple and get that dividend
or you put money in a savings account and get
some interest. Which is almost nothing these
days. Right. But even that tiny amount, the IRS
classifies that as portfolio income, not passive
income. Why does that distinction matter? I mean,
is it just semantics? Or does it have real world
consequences? Oh, it has huge consequences when
you get to tax time. Specifically, it matters
when it comes to losses. Let's say you have what
the IRS defines as passive losses, maybe from
a rental property that's not making money yet.
You generally cannot use those passive losses
to offset your portfolio income. So you can't
use your bad real estate deal to cancel out the
taxes on your stock games. You got it. They're
siloed. The IRS wants to keep them separate to
prevent people from, you know, sheltering their
investment gains with paper losses from completely
different ventures. It's a way to stop people
from gaming the system. That's really interesting.
So for the rest of this conversation, we're probably
going to talk about passive income in that broader,
more colloquial sense. Money you don't actively
work for. Right. Money you don't work for. But
we have to keep that legal asterisk in our minds
that the IRS sees things differently. We do.
And there's one more nuance from the expert side
of our notes that I think really sets the stage
for everything else we're going to talk about.
Which is? The host perspective, the dream, the
Bali deck, is that it's free money. Right. But
the source material emphasizes over and over
again, passive income is almost never free. It
is an acquired income. What do you mean by acquired?
It means it usually requires one of two things.
Either a massive upfront accumulation of capital.
Cash. Lots of cash. Or it requires a long, intense
period of work, often unpaid work, before that
passive phase can even begin. So you're either
paying for it with cash you already earned through
active work. Or you're paying for it with sweat
equity up front. There's no escaping the payment.
Precisely. You have to build the hydroelectric
dam before you can sit back and watch the reservoir
fill up. You can't just stand by the river and
expect electricity. That is a perfect analogy.
Okay. Okay, so let's map out where we're going
today. We're going to start by looking at the
different vehicles for this income from the boring
bank accounts to... The volatile stock market.
A whole spectrum of risk. Then we're going to
get into real estate, which, as I mentioned,
has some fascinating philosophical baggage attached
to it. The improperty concept. Yes, I'm excited
to get to that. It's a real mind bender. And
then we'll touch on the new digital world, the
so -called loopholes or strategies, depending
on who you ask. Right. And finally, we'll take
a trip around the world to see how countries
like China and Russia and even Kazakhstan handle
this kind of wealth. Sounds like a plan. OK,
let's jump into section one, the spectrum of
income sources. And let's start with, I think,
the safest, maybe the dullest place you can put
your money, the bank. Deposits. Yeah, it's not
sexy, but it is the absolute foundation of the
financial system. The idea here is about as simple
as it gets. I give the bank my money. They hold
it. They pay me interest. But let's be real.
A standard savings account pays. What, pennies?
In many economic climates, yes. I mean, the real
rate of return can actually be negative once
you factor in inflation. Your money is losing
purchasing power. So what's the actual passive
income vehicle here? The sources highlight a
specific one, the certificate of deposit or a
CD. Ah, the CD. I remember my grandmother giving
me a CD for my birthday when I was a kid. I was
so disappointed because I couldn't spend it.
That is the entire mechanism of the CD. It's
a contract. You are literally agreeing to lock
away a fixed amount of money for a fixed period
of time, six months, a year, five years. You
are selling your liquidity to the bank. And in
exchange for me not being able to touch my own
money, they pay me a slightly higher interest
rate. Correct. It's a premium for stability.
The bank can lend that money out with more confidence
because they know you can't just walk in and
demand it all back tomorrow without paying a
massive penalty. Right, there are penalties for
early withdrawal. Big ones, yeah. And the sources
mention the scaling here. It's not a one -size
-fits -all rate. No, not at all. Generally, a
larger principle, meaning you deposit more money
and a longer term will yield a better interest
rate. A $10 ,000 five -year CD will pay a lot
more than a $1 ,000 six -month CD. So what's
the verdict on this? Who is this for? It is the
definition of low risk, low reward. It prioritizes
safety above all else. You aren't going to get
rich off CD interest unless you start with millions
and millions of dollars. But you also aren't
going to wake up and find your account balance
has dropped by 20 % overnight. Which brings us
very neatly to the vehicle where you can wake
up to a 20 % drop, the stock market. The market
route. This is where the majority of, let's say,
middle class passive wealth generation happens.
OK, but we need to break down the two ways you
actually make money here, because I think people
conflate them all the time. There's growth and
there is income. Yes. This is a really important
distinction. Mechanism number one is value growth.
You buy a share of a company for $100. The company
does well. It innovates. Its market cap increases.
The share is now worth $120. But that $20 is
theoretical. Right. It's just a number on a screen
until I sell it. Exactly. That is a capital gain
and it is only realized upon sale. It's not income
until you cash it out. The second mechanism,
the part that feels more like passive income,
is dividend payments. This is the actual check
in the mail or the deposit in my account. That's
right. This is distributed profit. The company
made money, they covered their costs, they reinvested
whatever they needed for future growth, and they
still had a pile of cash left over. So they cut
a check to the owners, the shareholders. The
source material specifically mentions index funds
here as the sort of default strategy for most
people. Why is that? Because picking individual
stocks is incredibly difficult. And the data
shows that even most professionals can't beat
the market over the long term. The whole monkey
throwing darts at a newspaper thing. Pretty much.
So an index fund like one that tracks the S &P
500 allows you to buy a tiny slice of the entire
market. You own a little piece of 500 of the
biggest companies. You aren't betting on one
horse. You're betting on the whole racetrack.
It just mirrors the market indices. But unlike
that CD we were just talking about. There is
absolutely no guarantee here. None whatsoever.
The biggest risk is volatility. Prices fluctuate,
sometimes wildly, based on news, on economic
data, on investor sentiment. Fear and greed.
Fear and greed. The source specifically highlights
value stocks. These are often established dividend
paying companies that maybe aren't growing super
fast as facing uncertainty in future earnings.
If a company has a bad year, what's the first
thing they can do to save cash? Cut the dividend.
Cut that dividend to zero. And suddenly your
income stream is gone. So this profile is for
the risk tolerant. If you're going to lose sleep
because your portfolio is down 5 % one week,
this isn't passive for you. It's just stress.
Exactly. Emotional labor is still labor. If it
costs you your peace of mind, it's not passive.
Okay. Let's move to the third lane. Bonds. I
feel like bonds are the thing everyone knows
they should understand, but almost nobody actually
does. It's true. They're sort of the sensible,
boring cousin of stocks. But understanding them
is key. Bonds are the lending route. So when
you buy a stock, you're an owner. When you buy
a bond, you are a lender. You become the bank.
You are the bank. You are loaning your money
to a government or a city or a big corporation.
And the sources say understanding the mechanics
here is really important because it explains
the risk profile. It does. A bond has a few key
components you need to know. There's the issue
price, which is what you pay. There's the face
value, which is what it's worth at the end. There's
the coupon rate, which is your interest, and
the maturity date, which is when you get paid
back. Okay, stop right there. Coupon rate. I
love this term because it feels so incredibly
old -fashioned. Why do we call it a coupon? It's
a great bit of financial history. It's because
before everything was electronic, bonds were
these beautiful, ornate, physical certificates.
Like a stock certificate you see in old movies.
Yeah, exactly like that. And at the bottom of
the certificate, they had literal tear off coupons.
Each one had a date on it. If your bond paid
interest every six months, you would take a pair
of scissors. Clip the coupon for that date, walk
into a bank, and hand it to the teller. No way.
And they'd just give you cash. They'd give you
your interest payment. That is why we still talk
about coupon clipping as a slang term for living
off investments. It comes from a literal, physical
act. That's amazing. So the income stream is
this. I buy the bond, I get my regular coupon
payments, and then at the very end, the maturity
date, I get my original loan amount back. Ideally,
yes. That's the plan. The main risk there is
if the borrower goes bankrupt. If the company
you lent money to goes under, you might get pennies
on the dollar or nothing at all. But there's
a twist here, according to the sources regarding
resale, because you don't have to hold it until
the very end. This is the part that confuses
people, but it's where the other major risk comes
in. You can sell a bond on the secondary market,
just like a stock, and the price of that bond
fluctuates based on what's happening with interest
rates in the wider world. OK, walk us through
that. Give me an example. OK, let's say you buy
a 10 -year government bond today that pays 5
% interest. It's a great deal. But a year from
now, the Federal Reserve raises interest rates
to fight inflation, and new bonds are being issued
that pay 7%. Suddenly, nobody wants my old 5
% bond anymore. Exactly. Why would they buy your
5 % bond when they can get a brand new 7 % one?
It's trash compared to the new stuff. So if you
want to sell it before it matures, you have to
sell it at a discount. You lose money on the
principal. But the reverse is also true. The
reverse is also true. Say you buy that bond at
5 % and then the economy tanks and the Fed drops
interest rates to 2%. My 5 % bond is now a gold
mine. It's a golden goose. It's paying way more
than anything else on the market. So you can
sell it for a premium for more than you paid
for it. That's why bonds, while generally safer
and less volatile than stocks, still carry interest
rate risk. OK, so we've covered deposits, stocks
and bonds, the big three. But there's one more
category in this section that I found really
interesting because it sounds like something
out of a gangster movie. Silent partnerships.
It does sound dramatic, doesn't it? But. It's
a very legitimate and actually pretty common
business structure. A silent partner is an individual
whose participation in a business is limited
strictly to providing capital. They're the money
guy, the bankroll. They are the bankroll. And
crucially, to qualify as a silent partner in
the eyes of the law and the IRS, they play no
role in the day -to -day management of the business.
So I can't just walk into the restaurant I invested
in and tell the chef to change the menu. You
cannot. You can't hire. You can't fire. You can't
make strategy decisions. If you start doing that,
you're no longer a silent partner. You're just
a partner and you lose your special status and
usually your liability protection. So because
you're purely providing capital, the income you
receive, which is an agreed upon percentage of
the gross profits, is considered passive. This
feels like one of the purest forms of passive
income we've discussed because it's explicitly
defined by the absence of labor. You are being
paid for taking a financial risk, not for doing
any work. Exactly. All right. Let's shift gears
a bit. We're leaving the world of paper assets
and moving into the physical world. Bricks and
mortar, section two, the improperty of real estate.
This is the classic path, right? When people
think financial independence, they usually think
of a portfolio of rental properties. For sure.
Buy a duplex, rent out one half, have the tenant
pay your mortgage while you live in the other.
It's the quintessential dream. It is. But the
source material took us down a really fascinating
rabbit hole here with a term I had never, ever
heard before. Improperty. Yes. This comes from
the economist J .A. Hobson, and he was writing
back in the 1930s. It's a concept that I really
wish was taught more in Economics 101 because
it reframes the whole conversation. So what is
improperty? Break it down for us. Hobson was
trying to make a critical distinction between
property that you use to create value, like a
hammer or a workshop or even your own home that
you live in, and improperty. Improperty, in his
view, is asset ownership used specifically for
the purpose of extracting income from other individuals.
Extracting is a very loaded word. It was meant
to be. He was launching a critique of the philosophical
underpinnings of landlordism. His argument basically
is that if I'm a carpenter and I build a chair,
I have created new value in the world. A chair
exists that didn't exist before. Right. But if
I own a plot of land and I just charge you rent
to stand on it, I haven't actually created anything
new. I am just charging you for access to something
that already exists. I am extracting wealth from
your labor simply because I hold the deed. It
connects to that old idea of economic rent, doesn't
it? The idea of unearned value. It does, very
closely. It's the idea of unearned increments
of value. But philosophy aside for a moment,
this tension is what makes real estate such a
polarizing topic in our society. Yeah. It's incredibly
lucrative for the owner, but it is often viewed
as parasitic by the tenant. Well, let's get into
the mechanics of it, because regardless of the
philosophy, people do it every day. The basics
of rental income. Tenants pay you rent. Or maybe
companies pay you royalties for using your land
for, say, a cell tower. The pros are pretty obvious.
It can be a very steady stream of cash flow.
It offers the potential for appreciation. The
building itself gets more valuable over time.
And unlike stocks, you have a high degree of
control over the asset. What do you mean by control?
You can renovate the kitchen. You can add a deck.
You can improve the landscaping. You can actively
force the value of your asset to go up. You can't
call up the CEO of Apple and tell him how to
design the next iPhone. A very good point. But
then there are the cons, starting with the high
initial investment cost. You can't buy a house
for $50 like you can a stock. Not unless you're
in a very specific market. And then there's the
biggest debate of all, the one that ties back
to our core theme. Is it actually passive? This
is the reality check. The source distinction
here is sharp. It says rental income is only
passive if it hasn't turned into an everyday
job. And anyone who has ever been a landlord
knows this struggle intimately. The managerial
duties. Finding tenants, screening them, running
credit checks, collecting the rent, which can
be a nightmare. Dealing with noise complaints
at 10 p .m. on a Tuesday. And, of course, the
dreaded 3 a .m. phone call that the water heater
has exploded and is flooding the downstairs apartment.
Right. If I am the one driving over there with
a wrench at 3 in the morning, that is not passive
income. That is a very stressful, very low -paying
job as a crisis manager. Exactly. That is labor.
So to make it truly passive, you have to use
what the industry calls the outsourcing loophole.
Which means you hire a property manager. You
hire a leasing agent. You pay someone else, usually
10 % to 12 % of the gross monthly rent, to handle
all the headaches. They take the 3 a .m. phone
call. But that changes the math completely. It
changes the math drastically. Now, that rent
check you receive has to cover the mortgage,
the insurance, the property taxes, a fund for
future maintenance, and the management fee. If
there is still profit left over after all of
that... Then you have passive income. Then and
only then. It seems like the profit margins are
much, much thinner than people realize if they
want true hands -off passivity. It sounds like
many passive real estate investors are actually
just buying themselves a part -time job as a
janitor and bookkeeper. That's a very accurate
way to put it. Now, before we leave this section
on property, we should touch on royalties. The
sources group this with real estate because it's
about payment for the use of an asset. But instead
of a physical house, it's an idea. intellectual
property things like books music patents trademarks
an idea that you own but the irs has a very specific
and interesting caveat here they do they have
to draw a line somewhere they say royalties are
only considered passive income if they are not
derived in the ordinary course of a trade or
business okay can you give me an example of that
that sounds a little abstract sure think of a
famous author like stephen king he writes books
that is his job That is his trade. The royalties
he gets from his publisher for The Shining are
considered active income. Why? Because he is
in the business of writing books. That's what
he does. It's the ordinary course of his business.
Okay, that makes sense. So what's an example
of passive royalty income? Okay, imagine a dentist.
She works on teeth all day long. That's her business.
But one weekend, she's tinkering in her garage,
and she invents a new, more ergonomic handle
for a dental mirror. She patents it. She then
licenses that patent to a big medical supply
manufacturer. Then she goes back to her normal
job of fixing teeth. And the royalty checks for
her invention start rolling in. Those checks
would almost certainly be considered passive
income by the IRS. She is not a professional
inventor. It was not in her ordinary course of
business. The income is derived from her ownership
of the patent, not from her daily labor as a
dentist. That is a fascinating distinction. It's
that separation again between the creator and
the owner. It is. And that actually leads us
perfectly into our next section, section three,
because the line between creator and owner is
getting really, really blurry in the digital
age. The gray area, what the source material
calls leveraged income. This is the stuff that
absolutely dominates your social media feed.
E -books, video courses, software as a service,
digital templates. I feel like every single person
I know has a side hustle trying to sell a PDF
template for something. And the source defines
this not as passive income, strictly speaking,
but as leveraged income. And the difference in
terminology is important. OK, what is the difference?
Passive income implies the asset itself does
all the earning. A stock dividend, for example.
Leveraged income, on the other hand, acknowledges
that you have to put in a massive amount of active
labor once to create a product that can then
be sold theoretically indefinitely. So if I write
an e -book on, I don't know, gardening, I might
spend 200 hours writing and editing it. That
is very active work. Huge active work. And it's
unpaid active work at that point. You're working
entirely on spec. But once that digital file
is created and uploaded to the server. The cost
to sell it to one person is essentially the same
as the cost to sell it to a million people. Zero
marginal cost of reproduction. That is the magic
of digital products. If you make physical chairs
and you want to sell 100 more chairs, you need
more wood, more glue and more hours from a carpenter.
Right. If you want to sell 100 more copies of
your digital course on gardening, you just need
a slightly better server hosting plan. The leverage
is immense. And that scalability is why it's
so easily confused with passive. Because after
the launch, after the hard work is done, it feels
passive. The sales come in while you're sleeping.
It feels passive because the labor is decoupled
from the individual transaction. You don't have
to be there physically or digitally when the
customer clicks buy. But the source material
warns us about a massive cognitive bias here.
The survivorship bias. Oh, it's huge in this
space. We only ever see the winners. We see the
one guy who made a million dollars selling a
course on how to make the perfect toast. We don't
see the 10 ,000 other people who spent six months
of their lives making a course that sold three
copies, two of which were to their parents. So
it's extremely high risk, high reward. It's almost
like a lottery ticket that you buy with your
time and debt of your money. That is a great
way to put it. The potential payoff is huge,
but the odds of success are very, very long.
Okay, we've covered the fun stuff, the dreams,
the different ways to make this happen. Now we
have to put on our suits and talk to the reality
police. Section 4, the IRS and the taxman. This
is where the rubber truly meets the road. If
you are in the United States, the IRS has a very,
very strict set of rules for what counts, and
it often doesn't align with our intuition. We
mentioned the buckets earlier, active, passive,
portfolio. But we really need to dig into the
wall that separates active and passive. The source
keeps mentioning this phrase, material participation.
This is the golden key. Material participation
is the legal test the IRS uses to decide if you
are an investor or if you are a worker in a particular
activity. How do they measure it? Is it subjective?
They try to make it as objective as possible,
and it mostly comes down to hours. There are
actually seven different tests you can meet,
but the big one, the one most people talk about,
is the 500 -hour rule. The 500 -hour rule. Right.
If you spend more than 500 hours a year on a
business activity, the IRS generally says, congratulations,
you are materially participating. This is active
income, not passive. So if I work too hard on
my side hustle, I can accidentally make it active
in the eyes of the IRS. Yes, exactly. And that
can be good or bad, depending on your situation.
It matters because, generally speaking, people
sometimes want income to be classified as passive
so they can offset it with other passive losses.
Oh, for the tax strategy. Right. But other times
you might want it to be active. For example,
you can't contribute to certain retirement plans
like a 401k from passive income. It has to be
earned active income. So the classification changes
your entire financial strategy. OK, let's circle
back to real estate for a minute. But the IRS
rules here are wildly specific. I was reading
through the source notes on what they call the
hotel exceptions, and it felt like I was doing
logic puzzles. It's designed to stop people from
gaming the system. The IRS needs to draw a clear
line. Are you a landlord, which is a passive
activity, or are you running a hotel, which is
a service business? So let's start with rule
number one, the seven days or less rule. This
one is huge for the Airbnb generation. The IRS
says that if the average period of customer use
for your property is seven days or less, it is
not a rental activity. Wait wait. If it's not
a rental activity, what is it? It's a trade or
business, like a hotel. So all those people renting
out their beach condos for the weekend. If their
average stay is short, they aren't passive real
estate investors in the eyes of the IRS. They
are active business owners. And this has a massive
tax implication. Which is? It means the income
might be subject to self -employment tax. That's
Social Security and Medicare tax, which is an
extra 15 .3 % tax hit that a normal, passive
landlord doesn't have to pay. Ouch. That is a
nasty surprise if you're not expecting it. A
very nasty surprise. Then you have the next rule,
the significant personal services rule. This
one applies if the average stay is 30 days or
less. So like a midterm rental for a traveling
nurse or something. Exactly. The rule says if
you rent for 30 days or less and you provide
significant personal services, it's not a rental.
It's a business. Okay. What counts as a significant
service? Is cleaning the place between tenants
significant? No. Things like cleaning the common
areas or fixing the roof don't count. That's
just considered normal for being a landlord.
But if you are changing the linens every day,
providing breakfast, offering guided tours of
the city, or providing room service. They're
not a landlord anymore. You're a bed and breakfast.
You're a business, not a passive investment.
And again, subject to that self -employment tax.
There was one more exception in the notes that
I had. thought was really niche but interesting.
The extraordinary personal services rule. This
covers things where the rental is incidental
to the service. Think about a hospital or a college
dorm. Technically, when you're in a hospital,
you are paying for the use of the room. But the
IRS says, no, the real value here is the doctors,
the nurses, the medical care. The room is incidental
to the service. So a hospital cannot claim its
room fees as passive rental income. That makes
perfect sense. It's logically consistent, even
if it's complicated. Now, I want to talk about
a specific loophole that the source material
flagged. It's called self -charged interest.
Ah, yes. This is financial inception. It gets
a little weird. It sounds like I'm lending money
to myself and paying myself interest. Effectively,
you are. Let's set up a scenario. Say you own
an S corporation. You are the sole owner. The
business needs a cash infusion. Instead of going
to a bank, you, the individual, lend the business
$100 ,000 from your personal savings. Okay, so
the business now owes me, the person, money.
And the business pays you interest on that loan,
let's say 5 % a year. Now, normally, where does
interest income go? Into that third bucket, portfolio
income. Right. But the self -charged interest
rule says that if the business uses that borrowed
money for a passive activity, say, buying a rental
property that you don't materially participate
in, then the IRS allows you to recharacterize
the interest income you receive. You can treat
it as passive income. Why on earth would I want
to do that? Because of the buckets. It's all
about the buckets. If you have other passive
losses, maybe that rental property you bought
is losing money on paper because of depreciation,
you can now use those passive losses to offset
this passive interest income. So I'm matching
the income to the loss to zero out my tax bill
on that interest. You've created a closed loop.
It's an incredibly clever and perfectly legal
tax planning strategy, but it's also incredibly
complex. It is. And this leads us to the big
critique in the source material. All of these
rules, self -charged interest, material participation,
depreciation, the hotel exceptions, they are
ridiculously complicated. Who is this system
actually built for? The wealthy. The sources
are very, very blunt about this. High income
groups use these complex passive income strategies
for tax avoidance. Because they're the only ones
who can afford the teams of accountants and lawyers
to figure this stuff out. That's a huge part
of it. But it's also that they have the capital
to diversify into all these different areas.
They have S -Corp, they have partnerships, they
have stocks, they have real estate. They can
structure their income to flow into the buckets
that have the lowest tax rates. Meanwhile, the
average middle class worker gets a... And the
IRS knows exactly what they made, down to the
penny. There is no hiding a paycheck. There is
no structuring your salary to be a capital gain
or to be offset by passive losses. This is what
they call the wage tax argument. Exactly. The
critics in our sources argue that the U .S. tax
code, in practice, has degraded into a tax on
wages. It primarily targets the working class
and the middle class. If you work for a living,
you pay high marginal rates. If you own things
for a living... living, you pay much lower rates
on capital gains or you use depreciation and
other tricks to pay nothing at all. The stats
in the source material seem to back this up.
Says about 20 percent of Americans receive some
form of passive income. But, and this is a huge,
but for the vast majority of that 20%, it's peanuts.
It's less than $5 ,000 a year. It's the interest
from a small savings bond or a tiny dividend
check from a few shares of stock. It's not the
Bali lifestyle. It's not the Bali lifestyle.
The number of people actually living the passive
income lifestyle is statistically tiny. It is
a game played at the very top of the economic
pyramid. So that is the rather complicated view
from the United States. But money is global.
I want to zoom out for our last section, section
five. How do other countries handle this? Is
the U .S. unique in this system that seems to
favor the owner over the worker? It varies quite
a bit, but you see similar patterns. Let's start
with Europe. Is there a unified European definition
of passive income? No, not at all. This is a
common misconception. The European Union is a
political union, but it is not a fiscal one.
The EU itself lacks direct taxation powers. So
every country is on its own. Every country makes
its own rules. France has different rules than
Germany, which has different rules than Ireland,
which is why so many tech companies are headquartered
there for tax reasons. But there is some kind
of standardization in reporting, right? To stop
people from hiding money. Yes. The OECD, that's
the Organization for Economic Cooperation and
Development, introduced something called the
Common Reporting Standard, or CRS. And what did
that do? It basically provides a guideline list
for financial institutions. It says, hey countries,
you should generally consider dividends, interest,
rents, annuities, and things like financial swaps
as passive income. It's a way to get countries
to share data with each other automatically to
catch tax evaders, but it doesn't dictate the
tax rate. For the rates, we have to look at specific
countries. Let's go east and look at China. Their
approach is stark. Very stark. China uses a flat
tax for passive and unearned income. It is taxed
at a proportional rate of 20%. 20%. Flat. Doesn't
matter if I make 100 yuan or 100 million yuan
for my investments. Correct. 20%. Now, contrast
that with active income wages from a job. In
China, that is subject to a progressive rate
that goes all the way up to 45 % for high earners.
Wow. Okay, so let me get this straight. If I
work incredibly hard and become a top surgeon
in China and earn a high salary, I give nearly
half of it to the government. Correct. But if
I just sit back and collect interest and dividends
on my massive inheritance, I only give 20%. That
is the math. And the source material explicitly
critiques this. It calls this system horizontally
unfair. Horizontal unfairness. Explain that term
for us. Horizontal equity is a basic principle
of taxation that says people with similar income
levels should pay similar amounts of tax. Big
sense. But in this system, two people could both
make, say, the equivalent of $500 ,000. The surgeon
pays a very high rate. The capital owner pays
a much lower rate. Their tax burdens are wildly
different, even though their income is the same.
It is horizontally unfair. And the source argues
this fails to regulate the income gap. It does
the opposite. It exacerbates it. It explicitly
favors capital owners over workers, which by
its very nature accelerates wealth concentration
at the top. OK, let's move north from there to
Russia. They are famous for their flat tax. Yes,
the 13 percent rule. For a long time, Russia
had a flat 13 % tax on almost everything, which
was a huge simplification of their old system.
For passive income, taxes withheld on security
sales if they're sold for a profit on bond coupons
and on dividends. And they have a very specific
formula for the calculation. Yes, it's very clear.
It is sales amount minus any sales commissions
minus the original purchase amount minus any
purchase commissions times 13%. It's purely a
tax on the net profit. What if I lose money?
What if I sell my stock for less than I bought
it for? If the asset loses value, no tax is paid.
It's very straightforward. You only pay tax on
your gains. And for non -residents, if I'm an
American wanting to invest in the Russian market?
The rules are slightly different. If you are
an outsider investing in Russia, the dividend
tax bumps up from 13 % to 15%. Okay. Finally,
let's look at Kazakhstan. The source highlighted
them as a really interesting outlier, using tax
policy in a very aggressive way. Kazakhstan is
essentially using its tax policy as a giant magnet
for capital. Their base rate for dividends is
an already low 5 % income tax. 5 % is incredibly
low. That's lower than sales tax in those places.
It is. But here is the real kicker. Dividends
and capital gains on securities that are listed
on the official Kazakh stock exchanges are often
excluded from taxable passive income entirely.
Excluded, you mean? 0 % tax? Tax -free. Zero.
Why on earth would they do that? What's the strategy?
The strategy is to encourage local investment.
They are trying to build up their domestic capital
markets. They want people, both local and foreign,
to move their money into the Kazakh stock exchange.
So they are effectively saying, if you come play
in our sandbox, you get to play for free. That
is one of the clearest examples of using a tax
code for social or economic engineering I've
ever heard. Absolutely. And it's a great reminder
that tax codes are never neutral. They're never
just about raising revenue. They always tell
you what a society or at least its government
values. And what do these examples tell us? They
tell us that Kazakhstan values capital investment
right now above all else. And they tell us that
in their own ways, both China and the U .S. currently
value capital ownership over labor. It's a pretty
sobering realization when you lay it all out
like that. It is. We have traveled a long, long
way in this deep dive, from the safety of a bank
vault to the volatility of the stock market,
from the philosophical concept of improperty
in the 1930s to the nitty -gritty of the IRS
seven -day rule for Airbnbs. And all the way
to the steps of Kazakhstan. It's been quite a
journey. If we had to boil all this down for
the listener, the one who started this episode,
dreaming of that beach chair in Bali. What is
the single biggest takeaway? I would say this.
Passive income is real, but it's not a verb.
It's a noun. It is not something you do. It is
something you own. You don't passive income.
You own assets that generate income. Exactly.
And the transition from being a laborer, someone
who trades their time for money, to being an
owner, someone whose assets generate money for
them, is the hardest financial lead anyone can
make. It's a fundamental shift in your relationship
with the economy. It requires sacrifice. It requires
risk. And as we learned with that leveraged income
section, it often requires a massive amount of
unpaid active work just to get the engine started.
And then if you're lucky enough to get there,
you find yourself in a system that is, in many
ways, designed to help you stay. there. The tax
code becomes a map, but it's a map written in
a language that heavily favors the owners. Which
brings us right back around to that provocative
thought from J .A. Hobson. Improperty. It's the
question that really sticks with me from all
of this. If our entire global economic system,
from the supposedly capitalist U .S. to supposedly
communist China, is wired to tax labor heavily
and tax ownership lightly. What does that say
about our collective values? Right. Are we implicitly
saying that the person who holds the wealth is
more valuable to society than the person who
creates the wealth through their work? It's a
profound question. Do we as a society value the
past, which is what accumulated capital is, more
than we value the present, which is active effort
and labor? That is definitely something to chew
on the next time you look at your pay stub or
the next time you see one of those get rich sleeping
ads online. That's it for this deep dive into
passive income. We hope you feel a little smarter,
maybe a little more cynical, and a lot better
prepared to argue with your accountant. Thanks
for listening. See you next time.