ON REAL ESTATE : Keep Most Tax Records for 3 Years

QUESTION: We are preparing our 1991 tax returns. Can you give us some guidance as to what records we have to keep and how long we should keep them? We recently moved from a larger house to a condominium and do not have a lot of storage space.

ANSWER: The easy answer 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 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 his or her books and records.

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

However, this is not always the 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 the IRS considers 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 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 (and properly) filed 1989 tax return (Form 1040) should be kept until at least April 16, 1992. Keep in mind, however, that if you obtained the automatic extension of the April 15 deadline, three years will be calculated from the date you actually filed your tax return.

There are different categories of records, and you may want to consider these areas.

Mandatory Documents

There are some documents that should never be destroyed.

For example, I recommend that you keep, forever, a copy of each tax return that you have ever filed. If you do not have a copy of any of your tax returns, you can get IRS Form 4506, entitled “Request for Copy of Tax Form.”

Your settlement sheet for each house you bought or sold should be kept. Keep in mind that if you bought your first house in 1970, and are now selling your last house, the purchase price (plus any closing costs) for that first house--and any subsequent houses--must be taken into consideration in determining what your capital gains tax will be.

Let me give you an example. If you purchased a 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 the rollover, your profit is $25,000 ($200,000 minus $175,000).

However, the burden of proof rests clearly on you, 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 some time in 1980. You will be required to produce proof of the cost of these 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. Unless you have kept the documents to prove what costs you have incurred above and beyond the purchase price, you may end up paying more tax than is legitimately required.

For example, items such as recording and transfer tax, settlement and closing costs such as title insurance and legal fees, are all legitimate items to be included, so that you can raise your basis, and thus lower your profit.

Again, however, the burden will be on you, the taxpayer, to demonstrate the authenticity of these costs.

Accordingly, anyone who buys or sells a house is well advised to keep the settlement sheets forever--or at least until the last house is sold and the applicable statute of limitations has expired.

You should also keep copies of all home improvement contracts and perhaps even copies of the canceled checks (so that you can demonstrate the value of the improvements you have made over the past many years).

Non-Mandatory Documents

Credit-card receipts, credit-card statements for purchases that have no tax implication, bills and statements from department stores, warranties that have expired and old car loan documents are all documents that can be destroyed at the end of each year. If there are no taxable consequences for these documents, there is no reason to keep those documents. They clutter up your files and are unnecessary for tax purposes.

Miscellaneous Documents

Every year, usually in January, we receive a large number of tax documents from our employer, our banks and other financial institutions, our stockbrokers and our mortgage lender. These are generally copies of documents that have been formally filed with the Internal Revenue Service. You should immediately check the accuracy of the numbers contained in those reports. If they are incorrect, contact the sender of the document and try to get it cleared up immediately. If you do not clear up the discrepancy, this information will be permanently embedded in the IRS computers, and if you report a different number to the IRS on your own tax return, this may very well trigger an inquiry (or audit) by the IRS.

These formal documents should be retained by you, for at least the period of the statute of limitations.

There are also record retention requirements regarding individual retirement accounts, travel and entertainment deductions, computer or automobile usage, and medical expenses and charitable contributions. I suggest you contact your own tax adviser for details.

Thus, even in the age of computerization, paper documents must be preserved so long as the IRS has the legal authority to audit your tax returns.

Benny Kass at Home Fair

Real estate and tax attorney Benny L. Kass, who is also a columnist for The Times and The Washington Post, will speak at workshops both Saturday and Sunday, April 4 and 5, at The Times’ third annual Home Buyers and Sellers Fair.

For times and details, watch upcoming issues of the Real Estate section.