diff --git a/docs/plugins.md b/docs/plugins.md
index e9d5a18a9e..897bf29507 100644
--- a/docs/plugins.md
+++ b/docs/plugins.md
@@ -152,8 +152,9 @@ and ask for approval. `ls` reports the installed commit without contacting the r
 ## Managed source ownership
 
 The [public source reference](../public-docs/plugins/reference.md#plugin-sources) owns identifier
-syntax and npm prerequisites; the [publishing guide](../public-docs/plugins/publishing.md) owns distribution. Both clients send the source unchanged
-through `installPluginSource`; only the daemon resolves host paths and acquires sources.
+syntax and npm prerequisites; the [publishing guide](../public-docs/plugins/publishing.md) owns distribution. The CLI resolves directory sources before
+calling `installPluginSource`; see the public source reference for CLI and app path semantics.
+Only the daemon reads plugin files and acquires sources.
 
 `ManagedPluginSources` owns acquisition and offline source description. Config stores the active
 directory; sources.json stores managed kind and the Git acquisition remote. The remote is needed
diff --git a/packages/cli/src/commands/plugin/index.ts b/packages/cli/src/commands/plugin/index.ts
index 3a126752c9..86dc5889b8 100644
--- a/packages/cli/src/commands/plugin/index.ts
+++ b/packages/cli/src/commands/plugin/index.ts
@@ -1,9 +1,12 @@
+import path from "node:path";
+import { expandUserPath } from "../../classify.js";
 import { createInterface } from "node:readline/promises";
 import { reviewPluginUpdates, type UpdateOutcome } from "./update.js";
 import { Command } from "commander";
 import type { PluginListItem, PluginLogEntry } from "@getpaseo/protocol/messages";
 import {
   formatPluginSourceReference,
+  parsePluginSourceReference,
   formatPluginIdentity,
 } from "@getpaseo/protocol/plugin-source-reference";
 import type { CommandOptions, ListResult, OutputSchema, SingleResult } from "../../output/index.js";
@@ -125,7 +128,18 @@ export async function runPluginInstallCommand(
   process.stderr.write(
     "Trusting plugin code: server code and preparation commands run unsandboxed on the daemon host; client code runs inside Paseo. Dependencies and future updates are part of the codebase you trust.\n",
   );
-  const sourceReference = formatPluginSourceReference(source, options.path);
+  const reference = parsePluginSourceReference(source);
+  let resolvedSource = source;
+  if (reference.kind === "directory") {
+    const directory = expandUserPath(reference.source);
+    // An absolute path can target a daemon on a different operating system.
+    const absoluteDirectory =
+      path.posix.isAbsolute(directory) || path.win32.isAbsolute(directory)
+        ? directory
+        : path.resolve(directory);
+    resolvedSource = formatPluginSourceReference(absoluteDirectory, reference.pluginPath);
+  }
+  const sourceReference = formatPluginSourceReference(resolvedSource, options.path);
   const data = await withPluginSourceClient(options.daemonTarget, (client) =>
     client.installPluginSource({
       source: sourceReference,
diff --git a/packages/cli/tests/e2e/plugin-lifecycle.test.ts b/packages/cli/tests/e2e/plugin-lifecycle.test.ts
index ce509af8e1..3e71b6b608 100644
--- a/packages/cli/tests/e2e/plugin-lifecycle.test.ts
+++ b/packages/cli/tests/e2e/plugin-lifecycle.test.ts
@@ -8,11 +8,13 @@ import {
 } from "../../../../scripts/test-support/npm-registry.mjs";
 import assert from "node:assert/strict";
 import { execFile } from "node:child_process";
-import { mkdtemp, readFile, rm, writeFile } from "node:fs/promises";
+import { mkdir, mkdtemp, readFile, rm, writeFile } from "node:fs/promises";
 import { tmpdir } from "node:os";
 import path from "node:path";
 import { pathToFileURL } from "node:url";
 import { promisify } from "node:util";
+import { once } from "node:events";
+import { WebSocket, WebSocketServer } from "ws";
 import { connectToDaemon } from "../../src/utils/client.ts";
 import { createE2ETestContext } from "../helpers/test-daemon.ts";
 
@@ -45,6 +47,81 @@ async function main(): Promise<void> {
     );
     await writeFile(path.join(directory, "index.server.ts"), pluginSource);
 
+    // Observe real CLI requests while forwarding them to the isolated daemon.
+    const proxy = new WebSocketServer({ host: "127.0.0.1", port: 0 });
+    const sources: string[] = [];
+    proxy.on("connection", (socket, request) => {
+      const upstream = new WebSocket(`ws://127.0.0.1:${context.port}${request.url}`, {
+        headers: { authorization: request.headers.authorization ?? "" },
+      });
+      const ready = once(upstream, "open");
+      socket.on("message", async (data, isBinary) => {
+        const message = JSON.parse(data.toString());
+        if (
+          message.type === "session" &&
+          message.message.type === "plugin.source.install.request"
+        ) {
+          sources.push(message.message.source);
+        }
+        await ready;
+        upstream.send(data, { binary: isBinary });
+      });
+      upstream.on("message", (data, isBinary) => socket.send(data, { binary: isBinary }));
+      socket.on("close", () => upstream.close());
+      upstream.on("close", () => socket.close());
+    });
+    await once(proxy, "listening");
+    const address = proxy.address();
+    assert.ok(address && typeof address !== "string");
+    const sibling = path.join(context.workDir, "x");
+    const caller = path.join(context.workDir, "caller");
+    await mkdir(caller);
+    await mkdir(path.join(sibling, "sub"), { recursive: true });
+    for (const target of [caller, path.join(sibling, "sub"), context.paseoHome]) {
+      await writeFile(
+        path.join(target, "paseo-plugin.json"),
+        JSON.stringify({
+          id: "relative-cli",
+          requirements: { paseo: `>=${resolveCliVersion()}` },
+        }),
+      );
+      await writeFile(path.join(target, "index.server.ts"), pluginSource);
+    }
+    assert.notEqual(caller, process.cwd()); // The daemon inherits the test runner's cwd.
+    try {
+      for (const [source, expectedSource, expectedDirectory, extraArgs] of [
+        [".", caller, caller, []],
+        ["../x:sub", `${sibling}:sub`, path.join(sibling, "sub"), []],
+        ["../x", `${sibling}:sub`, path.join(sibling, "sub"), ["--path", "sub"]],
+        ["~", context.paseoHome, context.paseoHome, []],
+        ["~/.:.", `${context.paseoHome}:.`, context.paseoHome, []],
+      ] as const) {
+        sources.length = 0;
+        const result = await context.paseo(
+          ["plugin", "add", source, ...extraArgs, "--host", `127.0.0.1:${address.port}`, "--json"],
+          { cwd: caller },
+        );
+        assert.deepEqual(sources, [expectedSource]);
+        assert.equal(result.exitCode, 0, result.stderr);
+        assert.equal(JSON.parse(result.stdout).path, expectedDirectory);
+        const removed = await context.paseo(["plugin", "remove", "relative-cli", "--json"]);
+        assert.equal(removed.exitCode, 0, removed.stderr);
+      }
+      // An absolute path belongs to the daemon's platform, which can differ from the CLI's.
+      const windowsSource = `C:\\${path.basename(context.workDir)}\\missing:sub`;
+      sources.length = 0;
+      const missing = await context.paseo(
+        ["plugin", "add", windowsSource, "--host", `127.0.0.1:${address.port}`, "--json"],
+        { cwd: caller },
+      );
+      assert.deepEqual(sources, [windowsSource]);
+      assert.equal(missing.exitCode, 1);
+      assert.match(missing.stderr, /Plugin directory does not exist/);
+    } finally {
+      for (const socket of proxy.clients) socket.close();
+      await promisify(proxy.close.bind(proxy))();
+    }
+
     const install = await context.paseo(["plugin", "install", directory, "--json"]);
     assert.equal(install.exitCode, 0, install.stderr);
     assert.equal(JSON.parse(install.stdout).id, "cli-e2e");
diff --git a/public-docs/plugins/reference.md b/public-docs/plugins/reference.md
index d4d67fae9b..2a8714e4d7 100644
--- a/public-docs/plugins/reference.md
+++ b/public-docs/plugins/reference.md
@@ -2258,8 +2258,11 @@ failures stay inside the plugin error boundary.
 
 Paste one of these source identifiers into **Settings → Plugins**, or pass it to
 `paseo plugin install`. `paseo plugin add <source>` and `paseo plugin install <source>` are aliases.
-Absolute host paths are recommended because relative paths resolve against the daemon's working
-directory. The daemon expands `~` to its home directory.
+The CLI resolves relative directory paths from your current working directory and expands `~`
+to your local home directory, preserving any `:plugin/path` suffix. With `--host`, use an absolute
+path that exists on the daemon host; plugin files are read there and are never uploaded by the CLI.
+Paths entered in Settings resolve relative to the daemon's working directory, and `~` expands to
+the daemon's home directory.
 
 | Source                     | Accepted form                                                              | Example                                       |
 | -------------------------- | -------------------------------------------------------------------------- | --------------------------------------------- |