IRS Paper Trail Now a Bit Smoother

Paying taxes is plenty painful. Filling out the forms is no fun either. But what really galls many people is the record-keeping.

This country’s so-called self-assessment system--in which taxpayers themselves figure out what they owe--coupled with our labyrinthine array of deductions and tax brackets compel Americans to stuff shoe boxes and file folders full of receipts and pay stubs every year--and to keep them, in some cases, for years.

Records are the key to winning most disputes with the IRS. If what you did was legal and you can produce records to substantiate it, it’s likely you’ll prevail. The much-publicized shift in the burden of proof from the taxpayer to the IRS in court cases may someday make it a viable strategy not to keep records, but experts counsel against it. It’s hard to tell how courts will interpret it. Records may be more important, not less.

So if you don’t have the records, you could have a problem.

“The biggest quagmire that people can make for themselves is the failure to keep paper, to keep records,” said Fairfax, Va., lawyer and author Robert G. Nath. “Tax life would be incredibly simpler if people only behaved like pack rats.”

New tax provisions effective in 1998 have shifted record-keeping requirements, for better or worse:

* Residences. One area where taxpayers will appreciate easing of the burden of record-keeping involves the sale of a home. Americans who sell their primary residences no longer pay tax on profits, up to $500,000 for a couple. Gone is the old rollover option under which home sellers could defer tax by buying another residence of the same or higher value than the old.

Under the old system, taxpayers were supposed to keep cumulative records of all homes they had owned, so that when they finally sold the last one it would be possible to compute the taxable gain.

So now all those records you’ve been keeping on your house--the purchase price, the improvements, the home office deductions, and so on--can trundle off to the ash can (unless you’ve got a really expensive house), right? Not exactly.

First, if you’ve deferred the gain on the sale of a house in the past and rolled it into your current one, you’ll need your records to compute the gain when you sell. If the house sells for less than $500,000 you’re not likely to be challenged, but if it’s close now and might go over by the time you sell, you’ll want to be able to show how much you’ve put into it.

Also, single people can exempt only $250,000 from tax, so if you are divorced or widowed, say, and end up with the house, the tax ceiling is suddenly a lot lower.

Second, while it’s true that you won’t have to keep records of costs associated with past houses, lawyers, accountants and other experts advise that you hang on to documents that show how much you paid for the house, the cost of major improvements you have made over the years, and any depreciation.

Houses, they note, can be very long-term investments, and while $500,000 may seem like a lot today, inflation will certainly erode it over the years.

“The point is, now you only need to save the records . . . really for the life of that one house,” said Steven W. Scheibe of the Chicago office of Coopers & Lybrand.

* Individual retirement accounts. The new Roth IRAs, which are funded with nondeductible contributions and are not taxed at withdrawal, should be a lot less burdensome.

Holders of traditional IRAs must begin making minimum withdrawals at age 70 1/2. The amount is based on the value of the IRA and the life expectancy of the holder and his or her beneficiary, if any. If the account includes nondeductible contributions, the holder needs to have a record of those so he or she doesn’t pay tax on them again.

None of that applies to the Roth. However, it’s worth keeping a record of your contributions at least until age 59 1/2, since holders may make an early withdrawal of their contributions without tax or penalty.

While Roth IRAs may be simpler, the new education IRAs are not. These accounts allow people, subject to certain income limits, to contribute up to $500 a year to a tax-free account to pay higher education expenses.

These accounts are most valuable for very young children who have a decade or more for earnings to accumulate (no contributions are allowed after the beneficiary turns 18). The proceeds have to go for higher education expenses or they are taxed, and they must be used by age 30, though unused balances may be rolled over for the benefit of another child.

All of this means keeping track of not only the account but the age of the beneficiary. It means, presumably, keeping records to show any disbursements went to qualified higher education expenses.

* Capital gains. Lower rates still require hanging on to mutual fund statements, stock purchase and sale records, dividend reinvestment records and other documents.

“Some brokerage firms’ statements have improved greatly over years. Some give a year-end statement with all your activity, so you can just keep that rather than all the detail,” Coopers’ Scheibe said.

But when in doubt, keep the paper.

Some planners recommend investing in a three-hole punch and some loose-leaf binders and filing every statement that way.

Also, if you acquire stock via gift or inheritance, make a note of the “basis,” which is the amount, usually the purchase price, you subtract when you sell to calculate its gain. If it’s a gift, ask the donor what he or she paid; if an inheritance, the basis should be included in the estate tax return.

Many experts advise keeping tax returns indefinitely, though the supporting documentation can be discarded as years pass. The IRS has three years from when the return is filed to challenge most items, though it can be six years if there is “substantial understatement” (more than 25%) of your income. And in the case of fraud or failure to file a return, the IRS can come after you any time.

Records are helpful in planning and in business as well as with taxes.

“I’ve never been an enemy of keeping records a long time,” Nath said. “They don’t eat much. . . . They just sit there gathering dust. And the day you throw them out, without fail, the next day you’ll need them.”