Keep Tax Records Long Enough to Satisfy IRS

We want to become a paperless society, however, there are still many legal requirements directing what kinds of documents have to be kept by the taxpayer, and--more important--how long these records should be maintained.

Most of us like to go through our books and records on a yearly basis, throwing away unimportant papers and trying to determine which documents to save.

As is the usual case, the document we thought was so important last year is often now considered totally useless this year.

The easiest solution to record keeping is that you keep all of your records forever. However, this is not only impractical, but also unnecessary.

In general terms, the law requires that so long as the taxpayer’s return is open for audit by the Internal Revenue Service, the taxpayer is required to keep his or her books and records.

There is a three-year statute of limitations. Once this three-year period has expired, and the Internal Revenue Service is no longer permitted to examine your returns for a particular year and you do not have to keep your documents. They can be thrown away.

This is a very general oversimplification, however. The IRS is permitted to go beyond the three years if, for example, income has been substantially under-reported by the taxpayer. Additionally, there is no statute of limitations if a taxpayer files a false or a fraudulent return. The tax for that year can be audited--and indeed assessed--at any time.

If the taxpayer does not report an amount of income, and such amount is more than 25% of the income shown on the tax return, there is a six-year statute of limitations from the time the return is filed.

Most records, however, 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 1992 tax return (Form 1040) should be kept until at least April 16, 1996.

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. If you filed your return but did not pay your taxuntil a later date, the statute does not run until two years from the date the tax was paid. In other words, the statute of limitations for a particular return is three years from the date the return was filed or two years from the date the tax was paid, whichever is later.

That is the general law on the keeping of books and records.

There are many documents--particularly in the real estate arena--that must be kept longer.

If you bought real estate, whether it be your principal residence or investment property, you should keep all of your records for at least three years from the date you sell that property.

More important, as has been discussed earlier in this series, 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 that you have to go back to day your very first property was purchased.

Also, because the tax on the profit (gain) of real estate is now quite high--28% for federal purposes--it is critical that you keep careful and accurate records of all improvements made to the property.

Keep in mind that for every dollar that you can demonstrate went into home improvements, you are going to ultimately save 28 cents that does not have to go to Uncle Sam.

Example: If you purchased your house for $100,000, and made a major addition worth $75,000, your basis in the property is $175,000. When you sell the property later for $200,000, and do not take advantage of any of the tax savings devices, your profit is only $25,000 ($200,000 minus $175,000).

However, the burden of proof falls directly on you the taxpayer. It will not be adequate merely to tell the IRS auditor that you believe you put $75,000 worth of improvements on the house sometime in early 1980. You will be required to provide proof of the cost of these improvements. If you do not have this proof, there is a strong likelihood that the IRS agent will reject your claim of improvements.

Additionally, if you intend to take advantage of the once-in-a-lifetime $125,000 exemption, it should be understood that you are taking this exemption away from the profit that you have already made. Clearly, it is important to document what costs you incurred above and beyond the purchase price.

Many of us have found that our ultimate profit is well beyond the $125,000 limitation. Thus, every dollar that can be added to basis creates a savings for you and puts that additional money in your pocket for retirement purposes.

Items such as recording and transfer taxes, settlement and escrow costs, title insurance and legal fees, are all legitimate items to be added so that basis can be raised and thus your profits will be lower.

But the burden is on the taxpayer to demonstrate the authenticity of these costs.

I strongly recommend that anyone who buys a house should keep as a permanent record all of the settlement sheets. When the last house is sold, and the applicable statute of limitations has expired, then--and only then--should you destroy those vital documents.

It is also important to document the unallocated mortgage points that you were unable to deduct over the years. Points paid to obtain a refinance mortgage will generally not be deductible in the year they are paid. You have to allocate them over the life of the loan. For example, if you paid $2,000 in points, for a 30-year loan, you are entitled to deduct only $66.66 each year. However, if you sell the house in the fifth year, the remaining unallocated and undeducted points can be deducted in full in the year that you sell or pay off that loan.

Although you do not have to keep your tax returns beyond the period of the statute of limitations, I strongly recommend that these be kept forever. They do not take up a lot of room in storage, and you may periodically need to refer to them for reasons that go beyond an IRS audit. Often, a mortgage lender or other potential creditor may want to review your tax returns for the past few years.

If you do not have a copy of your tax return, you can obtain IRS Form 4506, entitled “Request for Copy of Tax Form.”

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.