How Long Should Tax Records Be Retained?

QUESTION: Every year at this time I resolve to throw out the many volumes of records that I have been keeping for many years. However, I am concerned about my potential liability if I should throw out the wrong documents and then find that the Internal Revenue Service suddenly wants to see those very same items. What are my rights with respect to those documents? Do I have to keep them forever?

ANSWER: The easy answer to your question is that, if space permits, you probably would be well advised to keep all of your records forever.

However, this is not only impractical but also is unnecessary.

Generally speaking, the law requires that as long as a taxpayer’s return is open for audit by the IRS, the taxpayer is obligated to keep his or her books and records.

Oversimplified, there is a three-year statute of limitations. If the three years have expired, and the IRS is no longer permitted to examine your returns for a particular year, then there is no need to keep all of your documentation.

However, the IRS may be permitted to go beyond the three years if, for example, the taxpayer has failed to file a return or has filed one that is considered to be fraudulent.

The tax for that year can be audited--and assessed--at any time. Additionally, if a taxpayer does not report an amount of income and such amount is more than 25% of the income shown on the tax return, the statute of limitations does not expire until six years after the return is filed.

Under the general period of limitations, however, most tax records need only be kept by the taxpayers for only three years after they file their tax returns.

For example, records relating to information on a timely filed 1987 tax return (Form 1040) should be kept until at least April 16, 1990. Keep in mind, however, that if you obtain an extension of the April 15 deadline, the three years are calculated from the date of the extension due date.

Some records must, by necessity, be kept for a much longer time.

For taxpayers involved in real estate transactions--whether for principal residence or investment--clearly the records must be kept from the date of purchase or acquisition until at least three years beyond the date of sale.

Because taxpayers are using such legal techniques as roll-overs and once-in-a-lifetime exemptions, it is critical to determine the basis (purchase price) when the property is ultimately sold.

Also, because the tax on the sale of real estate is now ordinary income rather than capital gains, it is important to be able to document improvements to the property.

For example, if you purchased your house for $100,000 and put on a major addition worth $75,000, your basis in the property is $175,000.00. If you sell the property later and do not take advantage of a roll-over, then your profit is $25,000 ($200,000 minus $175,000).

However, the burden of proof rests clearly on the taxpayer. It is not sufficient to tell the IRS auditor that you think you put $75,000 worth of improvements on the house some time in 1980. You will be required to produce proof of the costs of those improvements.

Similarly, if you want to take advantage of the over-55 $125,000 exemption, it must be understood that you are taking this exemption away from the profits that you have made. Again, it is important to demonstrate what costs you incurred above and beyond the purchase price.

For example, items such as recording and transfer taxes, settlement and closing costs, such as title insurance and legal fees, are all legitimate items to be added so that you can raise your basis, and thus lower your profit. Again, however, the burden will be on the taxpayer to demonstrate the validity of these costs.

Anyone who buys a house is well advised to keep the settlement sheet in perpetuity--or at least until the last house is sold and the applicable statute of limitations has expired.

As a result of a recent case dealing with the non-deductibility of points paid to refinance a mortgage, it is also important to keep documentation on your refinance settlement.

For example, if you paid three points on a $100,000 refinance loan, you will have paid $3,000 at settlement. If the refinance loan was for 30 years, you have to divide the $3,000 by 30 years, and each year you will be entitled to deduct $100.

However, if you sell the house any time before the expiration of the loan, the balance of the unclaimed deduction can legitimately be taken in the year that you sell the property. However, once again, the burden to produce proper records will be on the taxpayer.

With respect to the tax returns themselves, I strongly recommend that these be kept forever. They are not bulky, do not take up a lot of room in storage, and you may periodically need to refer to those tax returns--for purposes which may go beyond an IRS audit.