“My outdoors Youtube business brings in $40-50k per month, but I knocked down my tax bill by buying 4 fishing boats.”

— Noah (a Florida man)

Unfortunately, Noah (not his real name) understood just enough about taxes to shoot his business in the foot. Noah understood that 100% bonus depreciation (a powerful tax loophole which begins phasing out on January 1, 2023) would allow him to write-off 100% of the cost of qualifying business equipment. Noah also understood that due to the nature of his business (an outdoors themed Youtube channel which featured lots of fishing), fishing boats would qualify as business equipment. What Noah didn’t fully understand is that depreciation of business equipment is only temporary–you have to repay it eventually either through real physical loss of value or through paying more taxes at a later date. In this letter, I’ll explain exactly how Noah went wrong, how much his mistakes will cost him in the long run, and how you can avoid making the types of mistakes Noah made.

Noah’s big mistake

Noah spent about $50k on each boat. Purchasing all 4 boats cost him $200k which allowed him a $200k deduction. Given Noah’s typical revenue of $40-50k per month, the entire $200k deduction probably took place in the 35% tax bracket. That means Noah’s boat purchases reduced his 2021 tax bill by $70k = 0.35 * $200k. It also means he locked up $130k that he would have otherwise had in cash. This latter fact is the primary cause of Noah’s future problems. Let’s consider the three possible outcomes that can happen over the next several years.

Scenario #1: Noah uses the boats for a few years and then sells them for the same amount he bought them for. When he sells the boats, Noah will owe taxes on the entire sale amount of $200k (because he took a full $200k deduction in the year he bought the boats). Furthermore, since he took the deduction against ordinary income, that $200k from the sale is now taxed at ordinary income rates, not long-term capital gains rates. The taxes are exactly the same as he would have owed in 2021 if he not bought the boats: $70k. The boat purchase only allowed Noah to accomplish two things: (1) delay paying the $70k for however long he owns the boats and (2) keep the $70k of capital locked into a business asset in the meantime. It’s basically like the IRS is giving Noah a 0% loan of $70k which he doesn’t have to pay back as long as the money is locked into business assets.

Whether or not scenario #1 results in a better outcome than not buying the boats depends on whether

1. the additional business revenue Noah can generate with the $200k worth of boats, or
2. the income Noah could have generated by investing the $130k he would have had if he just paid the tax and not bought the boats

is more money.

For example, suppose Noah keeps the boats for 5 years. Before purchasing those boats, he already had 2 others. When I asked, Noah didn’t have any particular answer for how exactly his new four boats would allow him to make more Youtube videos or get more views. Optimistically then, let’s suppose that after paying marina fees, slip rent, boat maintenance costs, and fuel costs, he earns an extra $2k / year in profit. In reality, boats are very expensive to keep and maintain so it seems likely that Noah may not even make $2k extra after all expenses are paid, but we will assume he does make that profit each year. Over 5 years, he racks up an extra $10k in pre-tax profit. After taxes at 35%, he ends up with an extra $6.5k in profit. His $130k has become $136.5k after taxes.

Now consider the hypothetical alternative: Noah paid the $70k in taxes and kept the $130k in cash. He then invests the cash into the stock market. The stock market doesn’t guarantee any particular return, but over decades it does consistently produce an average annual return of about 10% per year. If Noah invested all $130k for 5 years with a 10% average annual return, then he would end up with $209.37k. If he chose to sell at the end of that period, he would pay long-term capital gains tax on the $79.37k profit. Assuming a 20% capital gains tax rate, that means Noah would have a post tax profit of $63.49k = 0.8 * $79.37k. In the end, he has turned his $130k into $193.49k after all taxes. That’s ***WAAYYYY*** better than if he had bought the boats!

Scenario #2: Everything is the same as Scenario #1, except we add in the reality that boats depreciate over time (physically wear down I mean, not just depreciate for tax purposes). If the boats depreciate 20% over the 5 years that Noah owns them, then what he bought for $200k he can only resell for $160k. Noah then owes ordinary income taxes on $160k instead of on $200k. Staying with our assumption that the proceeds fall into the 35% tax bracket, that means Noah owes $56k = 0.35 * $160k in taxes on the sale. Post-taxes, the sale leaves him with $160k – $56k = $104k. If we include the $6.5k in extra post-tax profit we calculated in Scenario #1, then at the end of the 5 years after all taxes are paid, Noah has $104k + $6.5k = $110.5k. He could have had $130k if he had just paid the taxes originally and put the cash in a zero interest bank account, or he could have had something like $193.49k if he had invested the $130k in the stock market (as we calculated before). This is an even worse outcome than Scenario #1!

Scenario #3: Noah keeps the boat forever. I won’t even do the exact math on this, because it would be so bad. The entire $130k Noah would have had if he had just paid the tax initially will eventually go to near zero as each boat’s real physical value diminishes and requires more and more maintenance. The combination of never paying the $70k in taxes and the tiny ROI on the boats ($2k / year) will be vastly outweighed by the real loss of value in the boats over time and the massive opportunity cost of not investing the $130k he could have had in the stock market. Compounding $130k at 10%/year for 10 years results in $795k before taxes… Noah tried to avoid $70k in taxes and by doing so, lost out on 10 times that amount in future opportunity.

What Noah could have done

Noah’s mistake can be summarized in one sentence: he made a financial decision based only on this year’s tax situation rather than a proper comparison of tax savings vs opportunity cost of getting those tax savings over the next several years.

When it comes to depreciating business equipment, the single most important thing to understand is that net benefit or cost depends on the time value of money. In other words, using equipment depreciation to delay taxes is only beneficial to the extent you can generate meaningful additional revenue from the equipment. If the equipment has little potential to increase revenue and moderate potential to incur extra maintenance costs, then delaying taxes to purchase the equipment is probably a bad idea. Stated like that, it sounds simple. It is simple, but you have to actually take the time to estimate revenues and maintenance costs. You’d probably be surprised how many entrepreneurs make the same sort of mistake as Noah.

Here is a basic decision process you can use to help you decide whether or not to buy a particular piece of business equipment that’s eligible for 100% deduction (note: this doesn’t include any type of inventory, consumables, or real estate — those each have different tax treatment).

1. Does the equipment cost more than $1,000 or does it seem expensive to you? If yes to either, then go to step 2. If not, buy the equipment–no need to proceed further.
2. Do you *need* the equipment to operate your business? If so, buy it. The tax deduction is just a bonus in this case since you need to buy the equipment no matter what in order to operate the business. If you don’t *need* it, then go to step 3.
3. Did you arrive at the idea to buy the equipment by thinking about how to grow your business or how to reduce taxes? If your original motivation was to grow your business, without considering taxes, then buy the equipment. You might still be wrong to do so, but if so that’s not so much a finance problem as an opportunity to learn from the mistake and develop your general business judgement. On the other hand, if your original motivation did involve tax considerations to partially or wholly justify the idea, then go to step 4.
4. Estimate the amount of tax money you’d save by multiplying your top marginal tax bracket by the cost of the equipment. I’ll call this number “Tax”. (e.g. for Noah’s $200k purchase at a 35% tax rate, Tax = $70k = 0.35 * $200k).
5. Calculate the amount of your own non-tax-savings money that would be put into the purchase. I’ll call this number “Equity”. (e.g. Noah spent $200k with Tax = $70k which means Equity = $200k – Tax = $130k).
6. Estimate how much additional annual revenue the equipment could enable your business to generate. I’ll call this number “R”. Estimating R is the hardest step with the most uncertainty, but it is necessary. A very simple, rough estimate is fine if it’s all you can manage.
7. Estimate your annual maintenance costs for this piece of equipment. I’ll call this number “M”. Again, a simple rough estimate is better than nothing.
8. Calculate the estimated additional annual profit “P” = R – M
9. Calculate the annual return on equity (ROE) as follows: ROE = P / Equity
10. If ROE is greater than 0.1, then buy the equipment. If not, then don’t.

If you’re good at math, you may have already noted several ways to improve the process as you were reading it. Even as it stands though, it’s a useful decision-making aid that can help you prevent enormous mistakes like Noah made with his boats. He would have gone through the process as:

1. Yes
2. No
3. Yes
4. Tax = $70k
5. Equity = $200k – Tax = $200k – $70k = $130k
6. R = $12k
7. M = $10k
8. P = R – M = $2k
9. ROE = P / equity = $2k / $130k = 0.015
10. Since 0.015 is NOT greater than 0.1, the answer is DON’T BUY

This process actually gives you more than just a binary answer. It gives you a framework to test different possibilities.

What if Noah could decrease maintenance costs to just $5k / year? Well, change the value of M in step 7 and then go through the remaining steps 8-10 to see what changes.

Or what if Noah hired a retired professional fisherman to do chartered fishing day trips, advertised as Airbnb experiences, without Noah ever being involved? That actually has the potential to scale Noah’s business enough to make the boat purchases worthwhile.

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