Financial

Write It All Off… or Not?

By Mark E. Battersby / Published November 2022

It’s no secret that all the assets so integral to the pressure cleaning business are costly and getting pricier every day. Our tax rules give the business the option of immediately writing off the entire cost of a newly acquired asset on the annual tax return. Or, with depreciation, the asset’s cost can be spread out to offset the revenue generated from it over its life.

     Now is the best time to consider how those depreciation rules and the tax law’s financial incentives can ease the annual tax bill and make acquiring assets less costly. 

     On the one hand you have an immediate write-off for the entire cost of newly acquired equipment or machinery using bonus depreciation or Section 179 first-year expensing. In an unprofitable year or if expecting more profitable years in the future when the write-off could reduce a higher tax bill, basic depreciation might be the best option.

Depreciation Basics

     Depreciation is the process of deducting the total cost of a business asset. Instead of writing the entire amount off in one tax year, portions of it are written off, or deducted, over time.

     The number of years over which an asset is depreciated is determined by its useful life. For tax purposes assets are included in different classes, with each class having its own useful life. A business that uses a different method of depreciation for its financial statement can decide on an asset’s useful life based on how long it is expected to be useful in the pressure washing operation rather than the IRS’s prescribed “useful” life.

     Usually, the cost of the asset, minus its salvage value, is divided over its useful life. That determines how much depreciation is deducted each year. There are a number of different methods of depreciation, including the following:

• Straight-line: Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life.
• Declining Balance: The declining balance method is an accelerated depreciation method that records larger depreciation amounts during the earlier years of an asset’s useful life with smaller depreciation amounts during the asset’s later years.
• Sum-of-the-years’ digits: Sum-of-the-years’ digits (SYD) is an accelerated method for calculating an asset’s depreciation. The method takes the asset’s expected life and adds together the digit for each year. If the asset was expected to last for five years, the SYD would be obtained by adding 5 + 4 + 3 + 2 + 1 to get a total of 15. Each digit is then divided by this sum to determine the percentage by which the asset should be depreciated each year, starting with the highest number in year one.

     The SYD method is more appropriate than the commonly used straight-line depreciation for assets that depreciate more quickly and have a greater production capacity in the asset’s earlier years than when it’s aged. The total amount of depreciation is identical regardless of the method used.

Speeding Up Write-Offs Really?

     Depreciation is the recovery of the cost of the asset or property over several years, with a portion of the cost deducted every year until the cost is fully recovered. Or, today the entire cost may be deducted in year one using tax incentives including the following:

• SECTION 179. A pressure cleaning business can choose to recover all or part of the cost of qualifying property, up to a certain dollar limit, in the tax year it is placed in service. The total cost that may be expensed under Section 179 is limited to the operation’s taxable income for the year.
• BONUS DEPRECIATION. There is a special depreciation allowance of 100 percent for some new and used property. Bonus depreciation enables a business to deduct a large percentage of the cost of purchased business assets, such as equipment, in the first year of their use. Bonus depreciation will remain at 100 percent through the end of 2022. It will then decrease by 20 percent each year.

     But this isn’t the only tax incentive for a pressure cleaning business purchasing qualifying assets. There are also special rules and limits for depreciation of so-called “listed property,” such as automobiles. Computers and related peripheral equipment are no longer labeled as listed property.

Viva The Confusion

     Most pressure washing businesses can take 100 percent  bonus depreciation this year and can always use the Section 179 expensing option. Many smaller businesses have other options.

     Obviously, if equipment has an expected life of 12 months or less, it can be treated as an expense and immediately deducted. That’s true even if some last more than a year just as long as the “expected” life is less than one year.

     Bonus depreciation is often confused with Section 179 deductions as the two serve similar purposes. Currently, both deductions can be used to write off the total cost of an asset purchase in the first year of the asset’s use.

     One significant difference, however, is that Section 179 can be claimed only if the business has a taxable profit for the year. Bonus depreciation does not require the business to report a profit.

Ignoring Fast Write-Offs

     Depreciation, in one form or another, must be taken into account on the annual tax return with that wear-and-tear otherwise accounted for. Faster write-offs with Section 179 expensing and bonus depreciation are another story.

     Writing off the full purchase price in the year of acquisition can mean saving tax dollars for that year and boosting cash flow—if the business has profits or cash flow to take advantage of those immediate deductions. After all, faster write-offs mean trading immediate savings for deductions in subsequent years, so over the life of the asset tax savings from depreciation even out.

     Of course, if the equipment purchases during the year are significant relative to pre-tax income, it often makes sense to pass.

Depreciation Recovery Can Be Expensive

     Keeping in mind that what the tax laws giveth, the tax laws can taketh away; don’t overlook depreciation recapture. Quite simply, when an asset is sold or traded, the pressure cleaning business might have to recapture some or all of the depreciation taken.

     In the past recapture could be postponed by trading the equipment or property for new or related equipment or property in a like-kind exchange. Unfortunately, tax law changes in 2017 now allow like-kind exchanges only on real property such as land, buildings, and other fixed property.

     The restrictions on using like-kind exchanges to avoid that expensive depreciation recapture might not be so bad if the pressure cleaning operation buys new equipment—and writes off the cost in the same year the old equipment is sold. The property sold must be at least equal the gain on the property sold and Section 179 or bonus depreciation used in the same year.

Payback Analyzing

     Before making a substantial investment in equipment or other business property, every contractor, business owner, or manager should calculate how much return will result from that expenditure. The concept is simple: How long will it take for the cash flows from the investment to equal its cost?

     Just because a tax deduction will result doesn’t always mean it will be a smart move. After all, the lower the tax bracket the pressure cleaning operation is in, the less that tax deduction is worth.

     Although there are a number of methods for analyzing the payback period of newly acquired business assets, in many cases there will be no need for a sophisticated, or even any, analysis. The dollar threshold for analysis usually depends on how big the business is.

     One approach to analyzing the payback period ignores the time value of money and is a poor choice for longer-term projects, but it is relatively simple: How long will it take for the cash flow generated from the asset to equal its cost?

Abandon It

     Finally, it is not unusual for a business to keep no longer used, outdated, or obsolete and scrapped equipment or other business assets on the books. If that property has been fully depreciated, there is, of course, no financial or tax impact. However, if there are assets that weren’t fully depreciated, a tax deduction for an “abandonment” loss might be in order.

     Now might be a good time to replace old, worn-out property. After all, buying replacement equipment and other business property now might makes sense, particularly if the purchase must be financed. Remember though, no one wants to invest in equipment or other business property that will sit idle regardless of how low financing costs are.

Get Help

     Fortunately, strategies for using newly acquired business property to generate increased cash flow currently exist. However, as many contractors, distributors, and dealers have learned, our ever-changing tax laws make it difficult to get the full deductions they are entitled to for the tools, equipment, and even the pressure washers that are so essential to the success of every business. Seeking professional assistance is strongly recommended for any pressure cleaning business seeking reduced equipment costs and smaller tax bills.