Keeping Tax Records

Perhaps you were hoping to contribute in a mild way to the waste pollution by discarding old financial records. However, you may need to hang on even longer.

Keep Everything?
Along with old theater programs and bronzed baby shoes, you may have folders of canceled checks, bank statements and income tax records going back perhaps as far as the 1940’s. You ask: “Which of these can be dumped?”

The traditional answer has been that “virtually everything except tax records for the past three years may be discarded.” Taxpayers are required to retain documentation supporting claims on tax returns only until the statute of limitations has passed, a period of three years.

However, the catch is that the three-year rule does not apply if the IRS claims your return has been false or fraudulent. It also does not apply if a prior year’s return is in question, such as for the prior purchase of a “tax shelter.”

In addition, documents supporting a tax-loss carry forward, charitable carry forward, or depreciation schedule should be kept until they are no longer relevant.

New Retention Rules
Because of the rules on the retention of certain tax records, in years to come many taxpayers will have to save more papers for longer periods. For example, anyone with passive losses that cannot be written off in the current year will have to retain the documentation until at least three years after the losses have been used. Taxpayers with non-deductible IRAs will have to hold on to all records pertaining to those accounts as long as the IRAs are in force, including tax returns and/or IRS Forms 5498, 1099-R and W-2P. This could be 20 to 40 years.

Documentation detailing the acquisition and improvement of a primary home as well as a second home now must also be retained, not just to be able to prove one’s basis but because the IRS requires it. Form 2119, giving details on the sale or exchange of a principal residence, must be kept as long as the costs of the home could be at issue. Since residence gains are “rolled up” into the successive purchases, a mobile family will accumulate many records. Otherwise, the taxable gain at the last sale will be overstated.

To make matters worse, if all this record keeping requires you to rent a U-Haul or a storage facility, the cost is generally not deductible.

Document Retention Schedule
Unless you operate a business, the required record keeping can be relatively simple. Because the burden of proof rests with the taxpayer, it is to your advantage to retain accurate and complete records, especially for deductions. The IRS generally will disallow deductions that cannot be adequately substantiated. This can often result in a 5% negligence penalty in addition to the tax and interest.

For many years, the primary information returns (IRS forms reporting amounts distributed to taxpayers that by law must be completed by banks, companies, etc.) that needed to be retained were merely those for interest or dividend income (Form 1099), and wages or salaries (W-2 Forms).

With computers and advanced technology, it is easy for the IRS to cross-check additional income sources, such as state and local tax refunds, social security benefits, IRA contributions and IRA and pension disbursements. The IRS can easily match information on alimony payments and mortgage interest deductions.

In addition to information returns, certain personal records should be retained, such as canceled checks, bank statements and receipts. These records are necessary to substantiate medical expenses, interest and taxes paid, charitable contributions and other deductible items.

It is also important to maintain investment information, such as stockbrokers’ advice and real estate records, showing purchase price, proceeds from sales and investment-related deductions. If you own securities, it is important that you maintain a record of each security owned, including stock splits and stock dividends, to help determine your cost basis. Certificate numbers, number of shares and sales prices should be maintained.

As a general “rule of thumb,” one should save a record if it may be used for legal or tax oriented purposes or if the cost or ownership of an item may be questioned in the future.

We could talk all day about basic guidelines, but the more conservative approach is “If in doubt - keep it!”