No one wants or likes to keep unnecessary papers. Taxpayers should go through their files at least once a year, keeping what you think is important, but discarding a lot of unnecessary documentation. Often, the document we knew was so important last year is now considered totally useless. Clearly, those documents which are not used for tax purposes can be thrown out on a yearly basis -- such as department store statements.
Unfortunately, neither the Internal Revenue Service nor the Internal Revenue Code gives us any clear guidelines as to what records must be kept and what can be destroyed. The IRS merely states that records should be kept "for as long as they are important (or material) for any Federal tax law."
In general terms, this means that while the taxpayer's return is subject to 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 for the IRS to assess a tax and impose a penalty on the taxpayer. Once this three year period has elapsed and the IRS is no longer permitted to examine your returns for a particular year, you can toss out your records. You should note that the three years begins when the tax return is due; if you filed early, the due date is still the target date. Keep in mind, however, that if you obtained an extension of the April 15 deadline, the statute of limitations begins to run from the date you filed your return.
If you filed your return but did not pay your tax until a later date, the statute does not run until two years from the date the tax was actually paid.
However, as in many areas of the law, there are exceptions to the rule. The IRS has the right to go beyond three years if, for example, income has been substantially under-reported by the taxpayer. Under these circumstances, the IRS can go back six years. Furthermore, there is no statute of limitations where a taxpayer files a false or a fraudulent return -- or does not file any return at all. The tax for those years can be audited -- and assessed -- at any time.
Most records, however, must be kept by the taxpayer for only three years after the tax return is filed.
That is the general law on recordkeeping. There are documents, especially in the real estate area, which you should keep your records forever.
Additionally, there are certain adjustments that can be made -- both on the buying and the selling side -- such as closing costs, real estate commissions, and recordation and transfer taxes. All of these items will be found on your settlement sheets, and clearly these sheets must be maintained in safekeeping.
More importantly, under the Taxpayer Relief Act of 1997, taxpayers can exempt the first $250,000 of profit ($500,000 for married taxpayers filing a joint return). The only way that you can determine the amount of your profit is to determine the basis (adjusted purchase price) when your principal residence is ultimately sold. This means that you may have to go back to the day when your very first property was purchased, to determine all of the legitimate items that can be added to basis.
Also, it is important that you keep careful and accurate records of all of your improvements. For every dollar you can demonstrate was spent for home improvements, you will ultimately save 20 cents that does not have to go to Uncle Sam. And that is only at the Federal level; you also have to consider any local or State tax.
Example: You purchased investment property for $100,000, and made a major addition in the amount of $50,000. Your basis in the property is $150,000. When you sell the property at a later date for $200,000, and do not take advantage of any of the tax saving devices, your profit is only $50,000 ($200,000 minus $150,000). For purposes of this example, I am ignoring depreciation.
However, the taxpayer has the burden to prove that he/she actually made the improvement and paid $50,000. It is not sufficient merely to tell the IRS auditor that you think you put $50,000 worth of improvements in the house sometime in the late 1990's. You will be required to provide proof of the cost of these improvements. If you do not have this proof, and cannot substantiate the improvements, there is a possibility that the IRS agent will reject your claim of improvements, or reduce the amount you are claiming. You will then have to take the matter to the Tax Court, in an effort to overturn the IRS decision.
If you plan to take advantage of the $250,000/500,000 exemptions for your principal residence, it is important to document what costs you incurred above and beyond the purchase price of your home.
Many long-time homeowners -- despite the mortgage meltdown where property values often significantly decreased, have found their profit is above these limitations. Thus, every dollar that you add to basis creates a significant savings for you, and puts additional money in your pocket for retirement purposes, rather than have to pay it by way of capital gains tax.
Items such as recording and transfer taxes, settlement and escrow costs, title insurance and legal fees, and real estate commissions are all legitimate items to be included in your computation of net gain. The best evidence of these expenses can be found in the settlement sheet -- called a HUD-1 -- when you bought your house.
I strongly recommend that anyone who buys a house keep a permanent record of all 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
The question is always raised as to whether tax returns should be kept beyond the statute of limitations. Once again, I recommend they be kept forever. They do not take up a lot of room in storage, and periodically you may want 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 it by sending for IRS Form 4506, entitled "Request for Copy of Tax Form." You can also get additional detailed information from IRS Publication 552, entitled "Recordkeeping for Individuals." To obtain both documents, you can pick these up at your local IRS office, or download them from www.irs.gov.
Thus, even in our information super highway, paper documents must be preserved so long as the IRS has the legal right to audit your tax returns