The question is often raised: How long do I legally have to keep all my books and records?
The easy answer is, if space permits, you probably would be well advised to keep all your records forever.
This is not only impractical, but also unnecessary.
Generally speaking, the law requires that as long as a taxpayer’s return is open for audit by the Internal Revenue Service, the taxpayer is obligated to keep the books and records.
Oversimplified, there is a three-year statute of limitations. Once the three-year period has expired, and the IRS is no longer permitted to examine your returns for a particular year, there is no need to keep all your documentation.
However, this is too easy an answer. 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 fraudulent. The tax for that year can be audited--and indeed 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 must be kept by the taxpayer for only three years after the tax return is filed. For example, records relating to information on a timely filed 1988 tax return (Form 1040) should be kept until at least April 16, 1991.
Keep in mind, however, that if you obtained an extension of the April 15 deadline, the three years are calculated from the date of the extended due date.
Some records must, by necessity, be kept for a much longer period.
For taxpayers involved in real estate transactions--whether a 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 rollovers and once-in-a-lifetime exemptions, it is critical to determine the basis (purchase price) when the property is ultimately sold. This means you have to go back to the day the property was purchased.
Also, because the tax on the sale of real estate is now considered ordinary income rather than capital gains (with a maximum cap of 28%), 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. If you sell the property later for $200,000 and do not take advantage of a rollover, your profit is $25,000 ($200,000 minus $175,000).
However, the burden of proof rests clearly on the taxpayer. It is not sufficient merely to tell the IRS auditor that you think you put $75,000 worth of improvements on the house sometime in 1980. You will be required to produce proof of the cost of those improvements.
Similarly, if you want to take advantage of the once-in-a-lifetime $125,000 exemption, you must understand that you are taking this exemption away from the profits you have already made. Again, it is important to document 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, the burden will be on the taxpayer to demonstrate the authenticity of these costs.
Anyone who buys a house would do well 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 ruling dealing with the ability to deduct points paid to refinance a mortgage, it is also important to keep documentation on your refinancing settlement.
For example, if you paid three points on a $100,000 refinance loan, you will have paid $3,000 at settlement. If the refinancing 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 you sell the property. However, once again the burden of producing proper records is on the taxpayer.
With respect to the tax returns themselves, I strongly recommend these be kept forever. They do not take up a lot a room in storage, and you may periodically need to refer to them for reasons that may go beyond an IRS audit. Usually, a mortgage lender or other potential creditor may want to review your tax returns for the past years.
If you do not have a copy of your tax return, you can get IRS Form 4506, entitled “Request for Copy of Tax Form.”
There are also record-retention requirements regarding IRAs, travel and entertainment deductions and computer or automobile usage. I suggest you contact your tax adviser for details.
Thus, even in the age of the computer, paper documents must be preserved so long as the IRS has the legal authority to audit your tax returns.